Are you retiring soon? If so, and you have a defined benefit pension plan, you may have to make a decision at the time you retire – should you take your pension as an income stream, or should you take it all as a one-time, lump-sum payment? In 2012 the lump-sum option may become a little less attractive.
As part of the Pension Protection Act of 2006, several new rules were introduced that effect the lump-sum payments from pension plans. First, the Act places a maximum on the amount that can be paid out annually. The largest annual amount a retiree age 62 to 65 can receive is $175,000 (in 2006 - adjusted for inflation going forward.) This limit is lower for younger workers. A cap on annual payments means a possible lower lump-sum payout, because companies use the monthly payout to figure out the present value lump sum.
In addition companies are able to assume a higher interest rate to calculate lump sum payments, using a blended corporate bond interest rate that was phased in over 5 years beginning in 2008. Because corporate bond rates are usually higher than Treasury rates, this would translate into a smaller lump-sum payout. To illustrate, let’s say your plan would pay you $2000 per month when you retire, and your life expectancy is 25 years. If your employer uses a 4% Treasury bond rate the plan would offer you a lump sum of $378,905 today in lieu of all those payments. If your employer uses a 5% corporate bond rate the lump sum shrinks to $346,120. When earning a higher rate of return you don’t need to start out with as much money to give you the income you need over 25 years.
These new rules are minimum standards and many companies will be more generous. Ask your employer how your plan will be affected. And if you are planning to retire soon consult a financial planner to determine which option is best for you.