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On February 26, 2015, the Government Accountability Office issued a report: Participants Need Better Information When Offered Lump Sums That Replace Their Lifetime Benefits. The report provides a useful summary of the current state of de-risking, focusing on transactions in which participants are offered a ‘lump sum window’ – a limited-time offer to certain participants to take their benefit as a lump sum. The report reviews what sponsors are doing and what issues are being raised by participants, participant advocates and regulators with respect to these transactions and includes a set of recommendations that could provide a template for further regulation or legislation.
In this article we review the report.
The report surveys the reasons why sponsors are de-risking (sponsors that have considered de-risking will be familiar with this material) and identifies some of the risks to participants of taking a lump sum offer. Interestingly, GAO found that fear of a plan default was the main reason participants cited for taking a lump sum; fear of outliving their assets was the main reason cited for not taking a lump sum.
For sponsors, probably the greatest significance of the report is its recommendations. These include: (1) sponsor reporting (e.g., to DOL) of de-risking transactions; (2) much more robust pre-decision disclosure to participants; (3) reconsideration of the use of a lump sum valuation interest rate based on a prior year ‘lookback rate;’ and (4) a timeline for adopting an update to current mortality tables.
Participant advocate groups have raised questions about the de-risking trend (see our article Concerns over pension de-risking), and we know that the Administration is concerned about it. The issue has not gotten the attention of many in Congress, although this GAO report, combined with the efforts of participant advocates and increased de-risking activity, may change that.
In what follows we review the report in more detail.
The report includes a brief review of 2012 de-risking activity: “GAO identified 22 plan sponsors who had offered lump sum windows in 2012, involving approximately 498,000 participants and resulting in lump sum payouts totaling more than $9.25 billion.” GAO’s findings were generally based on information it gathered with respect to these 22 de-risking transactions. One of its findings, however, was that there is inadequate public information about these transactions, and one of its recommendations was for increased reporting on them.
GAO described 6 reasons why sponsors undertake de-risking transactions:
PPA change to “more favorable” lump sum valuation interest rates. The change in lump sum valuation rates, made in the Pension Protection Act of 2006 (PPA) and fully phased-in in 2012, from 30-year Treasury rates to corporate bond yield curve-based rates, decreased the cost of paying lump sums to something close to the value shown on the books of the plan.
Current mortality tables. The forthcoming adoption of new mortality tables reflecting longer life expectancies makes paying lump sums now ‘cheaper’ than paying lump sums after the adoption of the new tables.
Rising PBGC premiums. Increased PBGC premiums make paying out lump sums, and thereby reducing headcount-based premiums, more attractive. GAO identified savings with respect to the flat-rate premium, although, as we have discussed in our article Reducing pension plan headcount reduces risk and PBGC premiums. For some sponsors, savings with respect to the PBGC variable-rate premium may be even greater.
Ability to choose a ‘lookback’ rate. As we have discussed (see, e.g., our article Pensions in 2013 – trends in interest rates and de-risking), sponsors often ‘peg’ the interest rate used to value lump sums based on a prior year lookback month. For instance, many sponsors use the interest rate for November prior to the current year. This approach to valuing lump sums can, as GAO put it, “be selectively used to financial advantage by plan sponsors when interest rates have decreased.” If current rates are lower than the lookback rate being used to value lump sums, paying lump sums may look like a ‘bargain.’
Ability to exclude certain plan benefits. A lump sum generally does not have to include the value of, e.g., subsidized early retirement benefits. GAO appears to be suggesting that that this ‘saving’ – if the participant takes the lump sum she does not get the more valuable subsidized early retirement benefit that she may ultimately qualify for – creates an incentive for doing de-risking transactions, but it does not provide any evidence in support of that theory.
Strategic considerations. GAO also noted that some sponsors wish to reduce plan liabilities because “their plan’s liabilities [have become] unacceptably large relative to the overall size of the business.” Other sponsors, after a series of corporate acquisitions, want to payout (and take off the plan books) “separated vested participants who had never been directly associated with their corporation.”
Weighing against a sponsor decision to de-risk, GAO identified: administrative costs associated with the de-risking transaction (e.g., data reconciliation and participant communications); adverse selection (e.g., less healthy participants taking lump sums and healthier participants taking annuities); the “sizeable immediate payments” required by de-risking; interest rate uncertainty (one might call this the fear of ‘de-risker’s remorse’); and foregone future returns on assets paid out in the de-risking transaction.
GAO identified 3 ways in which taking a lump sum may reduce the value of a participant’s retirement benefit:
Annuitizing a lump sum payment may not fully replace the value of the plan’s annuity. GAO discusses (at length) the fact that retail annuities generally cost more than the lump sum value of a plan annuity. Why might a participant want to take a lump sum and then buy a retail annuity with it, rather than simply opting for the plan annuity? According to GAO: “Most of the participants we interviewed who accepted lump sum payments told us that they did not trust the security of their plan benefit …, and some said they were encouraged by others to purchase a retail annuity.”
Rolling a lump sum into an IRA brings “management risks and challenges.” According to GAO, “No official statistics with respect to the disposition of lump sum window payments exist, but one retirement consultant’s survey suggests that just over half of participants roll over the full amount of their lump sum into an IRA.” Participants who roll their distribution into an IRA “must contend with 1) the potential of outliving their assets; 2) complex decisions concerning the investment of the lump sum and the drawdown of the assets; and 3) the difficulty of finding trusted advice.” We assume a general familiarity with these issues.
Using lump sums for immediate expenditures may have benefits but also consequences for retirement. Sponsors are generally familiar with the problem – long-term reduced retirement savings – this sort of ‘leakage’ presents. It is interesting, however, that GAO seems to have found that, in the cases it reviewed, the leakage was, arguably, positive: “Our interviews of participants presented with lump sum window offers found that only 2 of the 15 participants who accepted the lump sum cashed it out to pay for immediate expenditures. In both cases, the participants had important immediate needs associated with their expenditures.”
GAO identified 8 areas in which participants need information to make an informed decision about whether to take a lump sum. The following chart (from the report) provides a useful summary.,/p>
| Question addressing key factor | Examples of sub-questions for key factor |
| 1. What benefit options are available? | What is the monthly benefit amount at normal retirement age (the ‘do nothing now’ or ‘deferred annuity’ option)? Is there a subsidized early retirement option? What is the monthly benefit amount if payments begin now under the plan (the ‘immediate annuity’ option)? What is the lump sum amount (the ‘lump sum’ option)? |
| 2. How was the lump sum calculated? | What interest rates were used? What mortality assumptions were used?* Was the value of any additional plan benefits included in the lump sum? |
| 3. What is the relative value of the lump sum versus the monthly annuity? | How does the lump sum payment compare to the value of the plan’s lifetime annuity? Would it be possible to replicate the plan’s stream of payments by purchasing a retail annuity using the lump sum? |
| 4. What are the potential positive and negative ramifications of accepting the lump sum? | How could taking the lump sum affect beneficiaries? How could inflation affect the lump sum and plan’s monthly benefits? What are the investment risks? What are the longevity risks?* How could spending some of the lump sum affect its value over time? |
| 5. What are the tax implications of accepting a lump sum? | How would the lump sum payment be taxed? What rollover options are available and what are the tax implications for each?* Are there early distribution penalties? |
| 6. What is the role of PBGC and what level of protection does PBGC provide on each benefit option? | What is PBGC? How much of the plan’s monthly benefit would be protected by PBGC if the plan is terminated with insufficient assets to pay benefits? |
| 7. What are the instructions for either accepting or rejecting the lump sum? | What needs to be done to make either election? What is the deadline for the decision?* Does a spouse need to grant consent for either election? |
| 8. Who can be contacted for more information or assistance? | What is the contact method for questions? Is federal assistance available? |
The information described in this table is considerably more robust than what is required under current law, and GAO found that none of the 11 information packets it reviewed (from actual de-risking transactions) fully met this 8-part standard.
Based on these findings, GAO made the following recommendations:
DOL should: require plan sponsors to notify DOL, and provide pertinent information, at the time they implement a lump sum window offer; and (together with IRS and PBGC) “clarify the guidance regarding the information sponsors should provide to participants when extending lump sum window offers.”
The Department of the Treasury should: review its relative value regulations “to ensure these statements provide a meaningful comparison of all benefit options, especially in instances where the loss of certain additional plan benefits may not be disclosed;” review the lump sum valuation rules allowing the use of a lookback interest rate; and “[e]stablish a process and a timeline for periodically updating the mortality tables.” If these changes were adopted (and, where necessary, legislation authorizing them were passed), it would change de-risking practice significantly. The disclosure regime GAO appears to be proposing would require sponsors to provide considerably more information than they do now. And, in addition to increased disclosure, some of these proposals, e.g., the recommendation that Treasury re-visit its lump sum calculation rule (allowing the use of a lookback interest rate), might have a substantive impact.
GAO stopped short, however, of recommending restrictions on sponsors’ ability to do de-risking transactions.
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With this report, GAO aligns itself with those groups, including participant advocates and the ERISA Advisory Council, calling for increased disclosure with respect to de-risking transactions.
We will continue to follow this issue.