Executive Summary
In recent years, pension plans and their employer sponsors looking to “de-risk” their exposure have been increasingly offering “lump sum pension buyout” offers to employees, where a pensioner receiving ongoing payments has the opportunity to convert the remaining expected payments to a one-time lump sum that can be rolled over to an IRA.
Yet while the conversion of a lump sum to a pension isn’t always a bad deal – at least if the lump sum is ‘reasonably’ valued – in practice the lump sum offers have been so ‘modest’ that even a recent non-partisan GAO study raised the concern that participants may not be getting enough information (and therefore may not be making the right decision) when the offer comes.
Accordingly, the Treasury has announced plans to issue an updated version of Treasury Regulation 1.401(a)(9)-6, Q&A-13 and Q&A-14, that will limit the ability of pension plans to offer lump sum pension buyout offers to those receiving ongoing payments. And the IRS announced in IRS Notice 2015-49 that the new rules will be effective retroactively back to July 9th of 2015, rendering lump sum buyout offers dead, effective immediately.
Notably, the crackdown on the employee pension buyout offer will not limit the ability to choose a lump sum versus a pension at the time of retirement, but it will prevent those from receiving ongoing pension payments from commuting those payments into a lump sum. For most, that’s probably good news, given ‘questionable’ buyout offers (and Congress beginning to scrutinize various "pension advance" schemes), and concerns about the ability of some retirees to manage the investment and longevity risk that they take on with a lump sum. However, for those in poor health or who fear their underfunded defined benefit plan may default (and don’t want to rely on PBGC backing), the new rules have taken a potential buyout offer off the table. And ironically, while the purpose of the new rules was to shore up protections for pensioners, the elimination of yet another means by which plan sponsors can “de-risk” their pension exposures may only serve to further accelerate the slow-motion demise of the defined benefit plan altogether.
What Is A Lump Sum Pension Buyout Offer?
The basic concept of a “pension” is a lifetime stream of regular payments, generally made to employees upon/after their retirement until death. The pension payments are funded from a lump sum of assets held within a pension investment account, supplemented by new ongoing contributions from the employer sponsoring the pension plan. However, pension recipients don’t have access to the lump sum allocable to the payments they will receive; instead, they simply receive the agreed-upon payments as long as the pensioner is alive.
At the time of retirement – when the pension would begin – retirees often have the option to choose whether to receive the lifetime pension payments, or choose to receive a “lump sum” instead. The prospective retiree has the opportunity to evaluate the lump sum dollar amount available and what income it might potentially produce, compared to the guaranteed lifetime pension payments, and decide which to take. If the lump sum is chosen, it becomes the retiree’s responsibility to invest the money and generate the retirement income cash flows. If the pension is chosen, the payments begin and continue for life (and, potentially for the life of a surviving spouse as well, under a “joint and survivor” option).
Generally, once a retiree chooses to take a lifetime stream of pension payments, the decision is irrevocable. In fact, Treasury Regulation 1.401(a)(9)-6, Q&A-13 prohibits any change in the period or form of pension distributions after they begin, unless the change is associated with certain types of payment increases under Treasury Regulation 1.401(a)(9)-6, Q&A-14.
However, back in 2012 as Ford and GM were going through their pension plan woes, the companies submitted two Private Letter Rulings – PLR 201228045 and PLR 201228051 – which raised the question of whether a plan amendment that introduces a new (but temporary) option to elect a lump sum could be treated as a “plan amendment that results in increased benefits.” By doing so, the pensioner would have an opportunity to receive a lump sum (generally as an IRA rollover) for the remaining value of his/her payments, even though the payments had already begun, and the pension plan could “de-risk” by eliminating its future obligation to sustain the pension payments (as going forward, all responsibility would lie with the lump sum rollover recipient).
When the IRS agreed to the PLRs, it opened the door to what has since been dubbed the “lump sum pension buyout offer”, where pensioners receiving existing ongoing payments have the opportunity to convert those payments into a one-time lump sum rollover and extinguish their relationship with the pension plan. And from the plan’s perspective, this “lump sum risk-transferring program” was able to shift the investment and longevity risk from the plan sponsor to the retiree.
Given these ‘benefits’, and as the Pension Rights Center has noted, such lump sum pension buyout offers have become increasingly common in the past several years, especially since the new RP-2014 mortality tables from the Society of Actuaries will take effect for defined benefit pension plans in 2016, effectively increasing the plan liabilities (and the amount that would have to be paid as a lump sum to participants) by 3% - 8%. In other words, plan sponsors have been engaging in lump sum buyout offers not only to “de-risk” the plans, but also to get it done in advance of the new mortality tables that will pressure the plan sponsors to fund the pension plans even more.
The Problem With A Lump Sum Pension Buyout Offer And "Pension Advances"
Notwithstanding the IRS’ acquiescence in the Ford and GM private letter rulings, significant concerns have been raised about the appropriateness of allowing existing pensioners to receive lump sum payments. First and foremost, the problem is that permitting widespread commutation opportunities for pensioners can undermine the actuarial assumptions of the plan, limiting the available mortality credits, and ultimately resulting in less retirement income for prospective retirees.
The problem can be exacerbated even further by adverse selection, when those in poor health choose a lump sum (to preserve their remaining account balance in the event of early death), while those who are healthy keep their lifetime pension payments. If done repeatedly over time, the end result would be that the subset of pensioners who remain in the plan all have life expectancies materially beyond the average, such that the plan would end out being underfunded, ironically making the situation more tenuous for those who stick with the plan.
Furthermore, given that most people are not well equipped to conduct a rigorous analysis of their pension-vs-lump-sum decision, there was growing concern that – notwithstanding that the lump sum was supposed to be an offer for “increased benefits” – that the actual size of the lump sum was often a poor deal for consumers and insufficient for them to replicate similar benefits in the private market, as highlighted in a recent GAO report, along with anecdotal articles on MoneyWatch and even a writer from the Center for Retirement Research who discovered her own pension buyout offer would require a whopping 9.6% return over the next 7.5 years to replicate what her pension was due to give her. More recently, even Congress is discussing whether to intervene further to limit "pension advance schemes" with sometimes questionable terms.
In other words, while it’s conceivably possible that a lump sum pension buyout offer could be a great deal, where there is a very modest hurdle rate a portfolio would have to earn to generate similar payments, in practice most pension buyout offers weren’t turning out to be a very good deal for consumers. And of course, this all presumes that the retirees could effectively manage their own lump sum in the first place, which may often not turn out to be the case.
Or viewed another way, while employers sponsoring pension plans were interested in offering a lump sum pension buyout offer as a way to “de-risk” and get off the hook from managing the future investment and longevity risk of the pensioners, it’s not entirely clear how many pensioners were really in the position to take on and effectively manage that risk themselves. Especially if the value of the buyout offer wasn’t really a very good representation of “fair market value” and left the pensioners in the hole in the first place!
IRS Notice 2015-49 Limits Accelerated Lump Sum Pension Buyout Offers
Given these concerns about the rapid increase in pension plans soliciting buyout offers in the aftermath of PLRs 201228045 and 201228051 – and the high-profile GAO 15-74 report raising serious concerns about how such offers were being made to plan participants – the IRS issued IRS Notice 2015-49, indicating that it will be working with the Treasury Department to soon issue an updated version of Treasury Regulation 1.401(a)(9)-6, Q&A-14 to limit lump sum pension buyout offers.
Specifically, the Notice stated the IRS and Treasury intent to prohibit changes to the pension payment period for anyone receiving ongoing pension annuity payments, which would foreclose on any possibility of pension plans accelerating payments into a lump sum payout (except in the case of a plan termination). This would be accomplished by modifying the Treasury Regulation 1.401(a)(9)-6, Q&A-14(a)(4) rules that stipulate that changes to pension payments can be made via a plan amendment if there is a “benefit increase”, limiting such changes to ones that actually increase the ongoing payments and not situations that shorten (including down to a single lump sum payment) the benefit period. Similarly, the rules under Treasury Regulation 1.401(a)(9)-6, Q&A-13 that allow for certain changes in the annuity payment period would limit the ability of plans to accelerate the payment period via a plan amendment, even if the plan amendment also increases the amount of the annuity payments.
And notably, even though the amendments to these Treasury Regulations have not yet been created, the Service stated in IRS Notice 2015-49 that when the new rules are written, they will apply retroactively back to July 9th of 2015 (the date that the IRS Notice was released). Any “Pre-Notice Acceleration” of a lump sum pension buyout offer will be honored (i.e., the IRS will not challenge it) if the plan amendment was already adopted by the plan prior to July 9 of 2015, or if a clear intent to do a lump sum risk-transferring program was already communicated to the plan participants prior to July 9 of 2015, or if a prior PLR had already authorized the strategy (for a particular taxpayer). For all other pension plans, though, the opportunity to solicit a lump sum pension buyout offer is off the table, effective immediately, as even though the updated Regulations prohibiting those offers haven’t been written yet, their retroactive implementation will apply even now.
Implications Of IRS Notice 2015-49 On The Pension Vs Lump Sum Buyout Decision
The primary consequence of the new rules under IRS Notice 2015-49 will simply be the accomplishment of their precise and stated goal – to limit the ability of pension plans to offer lump sum buyout offers to existing pensioners receiving ongoing payments. Going forward, once pension payments begin for life, they must continue for life (unless the plan is outright terminated).
Notably, though, the new rules do not limit the decision of whether to elect a lump sum in lieu of a pension at the time of retirement, which is still permitted under the existing Treasury Regulation 1.401(a)(9)-6, Q&A-13(b)(1). For those who are transitioning into retirement and trying to decide whether to take the pension payments or the lump sum, it will still be necessary to analyze whether the lump sum is a “good deal” or not compared to the pension payments. Again, the purpose of the new rules is simply that, once lifetime pension payments are selected, there’s no longer any way to commute them into a lump sum later.
From the perspective of most employees, the changes under IRS Notice 2015-49 are probably good news, especially given the GAO 15-74 report about the questionable lump sum amounts that many plans were offering, not to mention the broader risk to pension plans if mortality credits were undermined and adverse selection becoming an ongoing issue. And as noted earlier, the simple fact that some retirees probably aren’t capable of taking on the investment and longevity risks themselves.
On the other hand, it’s worth recognizing that the loss of lump sum buyout offers will be unfavorable for some. Those who have developed adverse health events since their original pension election may have been looking forward to the opportunity to elect a lump sum buyout offer, as even a ‘questionable’ lump sum valuation is still favorable for someone with a known health issue and shortened life expectancy. In other words, if someone in poor health wanted to take advantage of (even a reduced) lump sum buyout offer, to preserve the unused account balance for heirs, it will no longer be an option.
Similarly, some people may have wanted the opportunity to take advantage of a lump sum buyout offer to get away from an underfunded pension plan, where there is at least some risk that the employer will default and the underfunded plan (and therefore the pensioner) will be forced to rely on PBGC backing instead. If the ongoing pension payments were already under the PBGC maximum benefit limits, this may have been a moot point, but for those with large pensions over the limits, the participants will now be forced to retain the risk of the plan defaulting with little alternative recourse. In other words, if someone was willing to take on the personal investment and mortality risk of a lump sum in order to get away from the risk the employer would default while the pension plan was underfunded, it’s no longer an option.
From the employer perspective, though, the irony is that while IRS Notice 2015-49 was intended to strengthen protections for pensioners, for employers already wary of their pension plans and the potential liabilities they create, the issuance of IRS Notice 2015-49 will probably be yet another factor that causes more plans to try to dial down from, freeze, or step away from their pension plans. After all, plan sponsors have just lost yet another way to de-risk their exposures. And although transferring the pension obligation to a fully-paid-up annuity is still feasible, that path remains more expensive (and therefore less appealing) than a lump sum pension buyout offer (though ironically, that is also yet another signal of how “not-a-good-deal” buyout offers have often been in practice).
The bottom line, though, is that with IRS Notice 2015-49 issued, and creating an effective date for the future Treasury Regulations retroactively back to July 9 of 2015, the reality is that lump sum pension buyout offers are already gone now. While the decision of whether to take a lump sum or pension payments will remain at the time of retirement, once the choice to receive pension payments is made, that decision is now ‘even more irrevocable’ than it was in the past – arguably a benefit to most, who in turn benefit from the protections that pensions provide, but perhaps an unfortunate loss to those in poor health, who wanted to get out of a “risky” underfunded pension plan, or for employers who have lost yet another means to de-risk their own pension exposures.
So what do you think? Was IRS Notice 2015-49 a good change to protect pensioners, even with a loss in flexibility and choice for those who might have wanted it? Will the new limits on de-risking pension plans make plan sponsors step up to take responsibility of the plans, or just hasten their demise?
I am turning 65 on October 28, 2015 and have already applied for Medicare which is active, although secondary to my employer provided insurance. I had decided to apply for my Social Security benefits to begin in January 2016. After reading your article I was concerned that I should apply immediately so I would receive my benefits starting in November 2015.
I presently have paid the Medicare premium personally from my checking account since I am not receiving SS benefits. The premium has been paid for October, November, and December 2015.
I went to the local Social Security Office but they were not very helpful. In your opinion, should I apply for SS Benefits starting immediately so I could fall In the hold harmless category? If I apply immediately and request that future premiums be deducted from my SS check would that be enough for me to avoid the 52% possible increase?
What would your advice be?
Ernst & Young is doing this right now with its pension plan. I calculated the NPV of the cashflows using the IRS mortality and interest rate tables (which EY claimed to used for their calculations), and I got a value that was THREE TIMES the offer that I received for the lump-sum buyout. To get their figure I have to use an interest rate of 7.4%, which hardly seems like a rate you would use for an investment that needed to be guaranteed 34 years from now. I sure hope that they’re not sticking the pension assets in the S&P 500, because that’s what that rate suggests.