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Pros and cons of offering a pension lump sum vs. an annuity

Trying to take some risk off the table with your pension plan? You’re not alone—defined benefit (DB) plan sponsors say reducing risk is their No. 1 goal.1 Reducing risk can not only help eliminate the risk of participants’ losing pension benefits, but can also reduce the size of your pension liability and the per-head portion of PBGC premiums.

The most popular ways we’ve seen to “de-risk” a DB plan are paying out lump sums or purchasing annuities (or some combination of the two).

Advantages and disadvantags of purchasing lump sums or annuities

Lump-sum paymentGenerally costs less than purchasing annuity contractsHigher risk that plan participant may mismanage their payouts and outlive their retirement funds since they aren’t required to roll DB plan assets into another qualified retirement plan or IRACritical to ensure plan participant is educated about retirement planning, investment strategies and tax implications so they don’t mismanage their funds
Annuity purchasePlan participant payment options mirror the benefit payments provided through the pension plan, which could include the option of guaranteed lifetime incomeGenerally costs more than offering a lump sum payoutAdequate funds to make an annuity purchase, must be timed when both interest rates and plan assets allow the liability to be transferred

Careful vetting of the insurer’s capabilities to transfer participant data in real time, and ensure retiree payments and participant communications are sent on schedule

Know your options

No 2 defined benefit plans are alike, that's why it’s important to choose the pension risk transfer strategy that works best for your situation and your goals. Let’s take a closer look at the types of lump-sum options and annuity purchases so you can make the choice that works for you.

Taking a lump-sum payment is a participant's choice
Except for small amounts, participants can’t be forced to take lump-sum payments. The option whether or not to accept a lump-sum payment rests fully with the plan participant.

Lump-sum options

Permanent lump-sum feature

Permanent lump sum distributions can help defined benefit plans remove risk gradually as individual lump sums are paid out to employees as they terminate or retire. However, risk is retained by the plan until the lump-sum payments are actually elected. Once added, lump-sum benefit options are protected under law and cannot be eliminated for benefits already earned.

Lump-sum window

Lump-sum windows extend a lump-sum option to a specific group of participants for a limited period of time, typically 3 to 12 months. The temporary nature of windows allows sponsors to transfer risk for the targeted group without incurring future additional costs for employees retiring in future years. Note: The design of a lump-sum window can’t discriminate in favor of highly compensated employees.

A note about terminated vested participants
Terminated vested participants (no longer active employees but not yet receiving a pension) are often targeted with lump-sum windows to transfer the risk of their long stream of future retirement payments.

Recently, several large employers have also offered lump-sum windows to retirees, though there are more restrictions and complexities when offering to participants already receiving benefits. Participants who already elected an annuity over a lump-sum payment offer cannot be approached with another lump-sum offer.

Annuity purchases

Buy-out annuities

In a traditional buy-out annuity purchase, an insurance company takes on future obligations of a portion of plan liabilities in exchange for a premium payment. Liabilities and associated assets are shifted out of the plan to the insurer, who manages risk and handles payments to plan participants.

When choosing an insurer, weigh your decision based not only on price, but also the financial strength of the insurance company. Financial strength is important since benefit payments moving out of qualified plans to insurance companies lose insurance coverage from the federal government’s Pension Benefit Guaranty Corporation (PBGC). 

Buy-in annuities

With a buy-in annuity, the underlying assets and liabilities are not removed from the plan. Instead, the annuity contract pays pension benefits back to the plan, which passes the payments through to participants. The value of the buy-in contract and the corresponding liabilities continue to be counted as part of the plan’s funding and accounting calculations and are factored into PBGC premiums until the buy-in is converted to a buy-out. At that time, assets and liabilities leave the plan.

Since risk is being retained by the plan, sponsors opting for a buy-in annuity may also want to consider liability-driven investing to help reduce liability risk without triggering negative accounting consequences.

Understand the big picture before you take action

Before you take any of these actions, make sure you carefully analyze the short- and long-term financial implications.

Both lump sum payments and an annuity purchase permanently reduce liabilities and can reduce PBGC premiums. However, parting with a potentially significant portion of plan assets should be carefully weighed as it may:

  • Reduce funded status, triggering additional cash contributions
  • Trigger settlement accounting as a result of recognizing previously unrecognized losses

We can help

Whether you’re looking to offset risk now or in the future, Principal has a team with DB expertise that can help meet your needs. Give us a call at 800-952-3343, ext. 22681 or contact your advisor to get started.

1 2017 Hot Topics in Retirement and Financial Wellbeing, Aon Hewitt

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.

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