This previously published article is part of 12 Days of Wealth Management: The Year in Review.
A growing number of U.S. companies are offering their current and former employees the option of taking early retirement benefits, including lump-sum payments. This places a large financial and investing decision in the laps of thousands of Americans - and opportunities for financial planners to help them make those decisions.
Some 35% of the more than 500 large American companies surveyed in a recent Aon Hewitt study said they were very likely or somewhat likely to offer a lump-sum payout to their retirees and employees in order to put a cap on their pension liabilities. Some of the biggest have already done so.
FLURRY OF OFFERS
Last spring, Ford said it would offer a lump-sum pension payment option to about 90,000 eligible U.S. salaried retirees and former employees. (This was in addition to the lump-sum payout option available to future retirees as of July 2012.) Ford was followed shortly by General Motors, which began offering lump sums to 42,000 of its 118,000 salaried retirees and beneficiaries. Other large companies taking similar steps include Archer Daniels Midland, The New York Times and Thomson Reuters.
The reason, of course, is to save money. The GM buyout was part of a program the company said would eliminate $26 billion in pension liabilities by the end of last year. ADM said its plan could "reduce its global pension benefit obligation by approximately $140 million to $210 million and improve its pension underfunding by approximately $35 million to $55 million."
"Post-retirement benefits have become so expensive for companies, and they're only just realizing it," says Kathy Johnson, a financial planner and tax consultant in Suwanee, Ga.
This is just the latest development in a trend that has been going on for more than two decades - namely, moving employee retirement benefits away from defined benefit pension programs to defined contribution plans, like 401(k)s.
Back in 1985, some 89 of the Fortune 100 companies offered a traditional defined benefit to newly hired salaried employees, according to human resources consulting firm Towers Watson. That has changed dramatically.
"Almost 30 years later, the pattern has completely flipped," Towers Watson found. "In the Fortune 100 of today, 89 companies now offer only account-based retirement plans to new salaried hires."
That places a big responsibility on individuals, their financial planners and other advisors. When given the option, most workers take the lump-sum offer.
But is that always the right option? And if so, what's the best plan for the money, which for many people can be a sizable amount?
"There is no one-size-fits-all answer," says Johnson, adding that she has been doing this type of analysis for many of her clients. "It depends on each individual situation."
BIRD IN THE HAND
One immediate consideration is whether the recipient needs money right away. But even if the answer is no, most people opt for the lump-sum payout - largely because of the "bird in the hand" argument.
"I usually tell people that the lump sum is the better way to go," says Jay Marsden, an estate planning and elder-law attorney in Holliston, Mass. "The main reason is to control your own destiny. First and foremost, the lump sum offers the client more flexibility."
For one thing, he notes, if the recipient waits to collect his pension but dies sooner than expected, he may not collect anything - or will have received a lot less than if he had taken the lump sum.
"If you wait and don't take the lump sum and pass away, it's all over - your heirs don't get anything," he says. If the money is in an IRA, the spouse or children can inherit it.
The death of the recipient isn't the only concern. What if the employer itself doesn't survive? "Many people today are worried about whether or not the company is going to be around when it comes time to start collecting the pension," Marsden says. As a result, they would rather handle the pension themselves.
ROLLING IT OVER
Unless specific exclusions apply, any lump-sum distribution is likely to be taxed as ordinary income, possibly with a mandatory 20% withholding applied for income taxes. If it's a "premature distribution" (that is, before age 591/2) from a qualified plan, there may be an additional 10% penalty.
If the money is rolled over into an IRA, however, taxes and penalties can be avoided. But the rollover must be done according to IRS regulations. That means it can't be sent to the recipient directly.