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Commentary

Trading Away Pensions

Pension plan participants are giving up their lifetime benefits to take lump sums. Why?

In recent years, defined-benefit plan sponsors increasingly have been offering participants lump sums in lieu of lifetime payments. Many plan participants have accepted these lump sums, even though doing so may not be in their best interests.

When participants take a lump sum, they take on two risks that their employer used to bear--investment risk (the risk that their investments might not perform as they expect) and longevity risk (the risk that they might outlive their savings). Plan sponsors have been happy to shift these risks off their balance sheets and onto participants.

Indeed, many plan sponsors have been working to rid their balance sheets of their defined-benefit liabilities entirely. To do so, sponsors can purchase annuities for their participants from a private insurance company or offer plan participants lump sums instead of their defined benefits. The costs of lump sums typically are much lower than the costs of buying annuities, so plan sponsors have a strong incentive to get their participants to take lump sums.

In fact, the U.S. Government Accountability Office in 2012 found that a handful of large sponsors offered lump sums to nearly a half-million participants and paid out almost $9.25 billion. (It is likely that the real number of lump-sum payments was even greater and has continued to grow in the past three years, but there is no way to know. The government does not require companies to report on the lump-sum offers they make.)

Reasons for the Surge
There are two reasons that plan sponsors are much more likely to offer lump sums than they once were: a regulatory change and the interest-rate environment.

Buried in the Pension Protection Act of 2006, the regulatory change modified section 417(e) of the Internal Revenue Code. This change phased in a new discount rate for valuing a participant's benefit as a lump sum. In general, this new discount rate (based on corporate bond yields) is much higher than the old discount rate (based on U.S. Treasury bonds.) With a higher discount rate, the mandated value of lump sums shrank, making them more appealing for employers. (The new discount rate was fully phased in by 2012, which explains the large number of lump sums in 2012 that GAO found.)

Meanwhile, pensions became riskier for companies' balance sheets as bond rates fell in recent years. This in turn meant that companies had to value their pension liabilities at lower discount rates, leading to higher pension liabilities on their balance sheets and higher required contributions to the pension plan. In 2012, there was a perfect storm: The value of the pension liabilities on balance sheets went up and the cost of giving participants lump sums went down, creating an ideal situation for companies to offload these liabilities by offering lump sums.

It is worth remembering that pensions didn't always mean enormous balance-sheet risk. In the 1990s, defined-benefit plans often helped the corporate bottom line as investments performed much better than expected, shrinking required contributions to the plans and often letting plan sponsors skip contributions altogether. In the 1980s, interest rates were high enough that plan sponsors could buy safe bonds to defease their pension liabilities, and they didn't feel pressure to invest in riskier equities to keep their defined-benefit plans affordable. Today, however, plan sponsors face very different incentives. Interest rates are low and investment performance is uneven, and employers are using lump sums as a way to get out of their pension obligations.

Why Do People Take Lump Sums?
Most people who study retirement security would encourage plan participants to keep their defined benefits in most cases. Participants who take a lump sum have to cope with longevity risk on their own, and lump-sum amounts are almost always inadequate to buy an annuity that would generate the same level of income the participant turned down. Also, participants might be tempted to spend their lump sums quickly, leaving them with inadequate resources for retirement. Finally, participants might have a hard time earning enough in investment returns to have adequate retirement income. Their investments might even lose money.

So, why do plan participants take lump sums?

My colleague Steve Wendel, head of behavioral sciences at Morningstar, and I testified on this very issue to the Advisory Council on Employee Welfare and Pension Benefit Plans this past summer. (The duties of the council are to advise the secretary of labor on improving ERISA.) We concluded that there are behavioral reasons that influence plan participants to take lump sums over a plan's annuity. For example, people are overconfident in their ability to reap benefits from investments. Lump sums, often viewed by participants as an avenue for investment growth, play into this bias. Also, people are loss-averse, and when offered a "limited window" to take a lump sum, they worry about leaving money on the table.

We are all aware of the rapid shift from a defined-benefit to a defined-contribution system over the past decade. But the trend of participants taking assets out of the defined-benefit system as lump sums is also important. Regardless of one's view on annuities, lump sums are not priced fairly for participants--at least vis-à-vis the price of a comparable annuity on the open market. For that reason, most participants should not take a lump sum, unless they have a strong need for the money immediately or have good reason to know they will not live long enough to collect their benefits.

This article originally appeared in the February/March 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.