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Firms offer lump-sum payouts to reduce pension risks

Firms offer lump-sum payouts to reduce pension risks

For years, employers have been considering whether offering pension plan participants the option to convert their monthly annuity payments into a lump-sum cash benefit made financial sense.

This year, three large and well-known companies—Ford Motor Co., General Motors Co. and NCR Corp.—turned consideration into reality when they announced they would be making lump-sum benefit conversion offers to tens of thousands of plan participants.

In April, Dearborn, Mich.-based Ford unveiled its conversion plan. Under its approach—the first of its kind—Ford said it would offer 90,000 U.S. salaried retirees and former employees the option to take their annuities as one-time cash payments.

Prior to Ford's action, a lump sum typically had been offered only when an employee terminated employment and was eligible for a pension benefit.

Ford's move was followed about a month later by Detroit-based GM when it said that as part of its broader pension risk-reduction strategy it would offer 42,000 salaried employees who retired after Oct. 1, 1997, and before Dec. 1, 2011, the choice of taking a lump sum or continuing to receive monthly payments.

Then in July, NCR, a Duluth, Ga.-based technology giant, said it would give 23,000 former employees who were eligible for, but not yet receiving monthly pension payments, the opportunity to convert future annuities to a one-time benefit payable in December.

After years of discussions, there are two reasons why some employers have moved ahead on these pension benefit conversions.

One reason is that provisions in a 2006 pension funding reform law went into full effect. The law allows employers to use higher interest rates, compared with prior rules, in valuing the pension benefit, essentially reducing the amount of the lump sum they have to offer.


In addition, the IRS released private letter rulings approving, for unnamed employers who had requested the rulings, arrangements in which retirees already receiving annuities could be given the opportunity within a specified timeframe to convert their annuities to a lump sum.

Prior to the rulings, there was no certainty on whether federal law permitted such an approach when participants already are receiving annuities.

The rulings “will be a roadmap for others to follow,” said Mike Archer, a senior retirement consultant at Towers Watson & Co. in Parsippany, N.Y.

Clearly, for several reasons other employers will follow the paths blazed by the two automakers and NCR, and offer to some or all plan participants the option to convert their current or future annuities to a lump sum pension payment, experts say.

Through the payout of a promised benefit as a lump sum, the size of an employer's benefit obligations is reduced. Along with that comes a smaller exposure to such risks as swings in investment results and interest rates that can make it difficult for employers to predict future pension plan contributions.

“Above all, liabilities are de-risked,” Mr. Archer said.

At the same time, with a reduction in plan assets and the number of plan participants, the overhead associated with offering a defined benefit plan will be minimized.

“When pension plans are smaller, there are administrative savings,” said Jonathan Barry, a partner in the Boston office of Mercer L.L.C.

Savings will come in several areas. For example, fewer plan participants will mean a corresponding reduction in premiums employers pay to the Pension Benefit Guaranty Corp.

The pension benefit guaranty agency's current annual base premium of $35 per plan participant is slated to rise to $49 in 2014, under legislation signed into law last month by President Barack Obama. After that, premium increases for plan sponsors will be linked to wage inflation.


In addition, a smaller pension plan means fewer assets to manage, and with that a reduction in fees paid to investment managers.

Still, there are costs associated with lump-sum conversions. For example, employers will have to track down participants who have earned a benefit and have left the company, but are not yet entitled to receive the annuity.

“That will require a fair amount of effort,” Mr. Barry said.

“Do I know where these people are? Is my data ready? There are operational issues,” Mr. Archer said.

There are other issues, not the least being the amount of money an employer may have to contribute to its plan under federal law in order to offer lump sums. Under the 2006 pension law, a pension plan has to be at least 80% funded in order for the employer to offer full lump sum payments.

The cost of bumping up plan funding to 80% is one reason some employers will not go forward on the lump sum approach, Mr. Barry said.

In addition, employers have to decide which pension participant groups it wants to offer the lump-sum conversion option.

Benefit experts suggest caution in offering the option to older retirees because of the increased risk of adverse selection. This could occur if a disproportionate percentage of retirees in poor health accept the lump-sum conversion offer, while those in good health reject the offer and stick with their monthly annuity.

In such situations, employers would have incurred the expense of paying out a disproportionate percentage of lump sums to participants living only a few more months, costing them a lot more compared with the annuities. This is because the plan would stop paying the annuity when the retiree died, or pay 50% of the annuity if the retiree had a surviving spouse.


The likelihood of adverse selection is enough of a cost concern that some companies will offer the annuity-to-lump-sum benefit conversion option only to participants not yet retired.

“You'll see some of this (lump-sum offers) made to deferred vested participants, but less so with retirees,” said Jack Abraham, a principal with PricewaterhouseCoopers L.L.P. in Chicago.

Those that do make such an offer to already retired participants receiving annuities should first apply for an IRS private letter ruling, experts say, because private letter rulings already issued apply only to the parties that requested them.

“I would not recommend proceeding for retirees without a private letter ruling,” Mr. Abraham said.