Lump-Sum Payouts and Annuity Purchase

Written by Hersh Stern Updated Monday, October 28, 2024

Upon leaving a job, whether for retirement or another change, huge numbers of employees yearly are eligible for a lump-sum payment from their employer's retirement plan. These millions of people need to choose whether or not to take a lump-sum payment; and if they do take it, what to do with it. For many of these employees, this money is the largest financial asset they own and may be their only private source of retirement income – income that must last the rest of their lives. Many will need assistance in understanding their options and choosing the best option for their circumstances. Their ultimate goal should be preservation of their retirement benefits in order to ensure a secure retirement for themselves and their families.

LIMRA conducted a study of employees retiring, changing jobs, or leaving the workforce and eligible for a lump-sum payment from their pension plan. The study's purpose is to assist pension companies with developing products and services that will help employees preserve their pension benefits. The study includes information on 1,763 employees eligible for a lump-sum payment from their employer's retirement plan: 684 employees who had retired in the past three years and 1,079 employees who had changed jobs or left the workforce in the past three years.

Size and Growth of the Market

Persons eligible for a lump-sum payment from their employer-sponsored retirement plan include those who are:

• retiring
• disabled
• changing jobs or leaving the workforce
• losing their job due to layoffs or corporate downsizing
• participating in a pension plan that is being terminated
• beneficiaries of a deceased participant in a pension plan

No accurate measure of the number of these persons exists. Only estimates are available and they vary considerably. In 1966 employer sponsored pension plans made benefit payments of $336 billion – an increase of 6 percent from 1995 and 31 percent from 1991. Of that amount, an estimated 28 percent1 or $94 billion was in lump-sum payments. This amount does not include more than $20 billion that plan participants choose to leave in their plans.2 A major study conducted by the U.S.

Department of Labor found that from January 1993 to September 1994, 940,430 workers aged 40 and older received a lump-sum payment.3 Subsequent analysis indicates that this study underestimates the number of people receiving a payment and that it does not include those who were offered a payment but who left the money in the plan. It does show that a large number of workers representing billions of dollars have the task of deciding what to do with this money.

The number of employees faced with this decision as well as the amount of money involved is not only large but increasing rapidly. Three factors contributing to this rapid increase are:

• the growth of defined contribution plans, particularly 401(k) plans
• the growth of participant account balances in defined contribution plans
• the increasing number of persons reaching retirement age early in the next century

Need for Assistance

Choosing the right option for their circumstances will be one of the most important financial decisions these employees must make. Persons eligible for a lump sum payment may have a choice of as many as six options. Their choices will include at least one or more of the following options:

• take the money in one lump-sum cash payment
• leave the money in the previous employer's plan
• transfer the money directly to an IRA
• take a cash payment and transfer it to an IRA within 60 days
• take the money in installments or purchase an immediate annuity

Each option has advantages and disadvantages. The options have differing effects on household income, tax liabilities, and preserving pension benefits. Not all options create the same estate value or survivor benefits for beneficiaries. Some options create maximum current income but not estate value. Other options create no current income but preserve estate value and spousal benefits.

Employees are strongly discouraged from taking a cash distribution. If they do, they will have a 20 percent withholding tax deducted from the payment and may incur a 10 percent penalty. The employee has 60 days to place this money into an IRA or qualified pension plan to avoid income and penalty taxes. However, the employee will not receive the 20 percent refund until income taxes are filed for that year; and, to avoid the taxes and penalty on the amount withheld, the individual must put, within the same 60 days, the equivalent of the 20 percent withheld into an IRA or qualified pension plan.4 The 10 percent penalty is not imposed if the employee died, became disabled, reached age 59½, or reached 55 in the year his or her employment was terminated. If the employee has a loan from the plan, it will have to repaid.

Size of Payment

The average lump-sum payment offered to a job changer is $22,230, with over half offered $10,000 or more. This $10,000 payment represents approximately 6 percent of household assets. For retirees, the average lump-sum payment offered is $119,200 with over half offered $55,000 – this $55,000 represents 23 percent of their household assets. In addition, nearly 15 percent of retirees have lump-sum payments valued at $250,000 or more and 1 in 3 retirees have values exceeding $100,000.When eligible for a lump-sum payment, the most popular option chosen is to transfer the money to an IRA – 2 in 5 employees choose this option. Approximately 1 in 5 employees leave the money in the employer's pension plan. Also popular among retirees is taking the money in installments or as a series of annuity payments. A cash payment is popular among job changers. Of those taking a cash payment, 45 percent saved some or all of the money.

Where Do They Invest or Save the Money?

Of those transferring the money to an IRA or taking a cash payment, the majority invested the money in mutual funds. Other savings and investment products include money market funds, savings accounts, annuities, stocks, and bonds. The competition for these investment dollars is high. No one company has a dominant market share. The five companies with the largest market share have a combined market share of less than 25 percent.

Those placing the money in an IRA show no clear preference for the type of company chosen to service the account. Banks and credit unions are the most popular among retirees, with 27 percent opening their IRA with this type of institution. Mutual fund companies are more popular with job changes–1 in 3 changers placed their IRA with a mutual fund company.

Leaving the money in the employer- provided pension plan is the easiest option for an employee to choose and one of the reasons that they do so. Other reasons include:

• The plan offers good service.
• They want to avoid taxes and penalties.
• The plan has good investment performance.
• They liked the investment choices.
• They would have a larger amount of money.

Sources of Assistance

The employer plays a critical role of providing information to employees on their options. Over 90 percent of employees felt they received adequate information from their employer. In addition, among the most useful sources for information, 3 out of top 4 mentioned by employees involved the employer. This information includes employer-written materials, employer seminars, and face-to-face meetings with the employer's staff. The other most useful source of information mentioned frequently is commercially available written material from bookstores.

Most do not seek the advice of a professional. They rely on either their own analysis or the help of family and friends. When they turn to a professional, they choose a financial planner, independent investment advisor or full service stockbroker.

Conclusion

Pension companies and employers are only in the early stages of understanding the needs of employees eligible for a lump-sum payment from their pension plan and designing products and services to help these employees. They can play a vital role in assisting employees in preserving their retirement benefits. Pension companies need to be more proactive in providing plan sponsors with necessary tools. One example is a service plan where the company assumes many of the administrative procedures performed by the employer. This service offers the employer the pension company's expertise in advising employers and cost savings. It offers employees access to a full time retirement specialist who works daily with employees in similar situations. In addition, the employer can tailor the services to meet the special needs of its employees.

Exhibit 2

Example of a Service Plan that Companies Can Offer to Employers

Servicing company provides a toll-free number to the employee – it could be the same number that the employee uses to call for other participant services.

• Servicing company provides a special toll-free number for employees and beneficiaries.
• Employer gives employees an instruction sheet directing them to the toll-free number.
• The toll-free number offers the employee the assistance of a retirement specialist to explain the process, help the employee complete the necessary forms, and answer questions.
• Servicing company mails necessary forms and supporting communication material.
• The company may also answer questions about the investment option available to the employees and provide material or assistance on choosing investment options.
• Employees are notified of the time limits and what will happen if they make no election.
• The company provides a compliance monitoring system that tracks when the notice of employees' rights, the spousal consent form, and tax-withholding notice are mailed.
• The company can answer questions on how to handle outstanding loans. For vested amounts less than $5,000, the company can follow the special procedures it develops with the employer.

Notes

1. Woods, John R., "Pension Benefits Among the Aged: Conflicting Measures, Unequal Distributions," Social Security Bulletin, Volume 59, No. 3, Fall 1996
2. LIMRA estimates approximately 23 percent of persons eligible for a lump-sum distribution leave this money in the employer's plan.
3. Retirement Benefits of American Workers: New Findings from the September 1994 Current Population Survey, U.S. Department of Labor Pension and Welfare Benefits Administration Office of Research and Economic Analysis, September 1995.
4. Participants in 457 plans are not allowed to transfer their distribution to an IRA, and cash distributions are only allowed after retirement.
5. Stable value investments – a type of investment that is only offered within pension plans. Stable value investments – also commonly referred to as guaranteed interest contracts (GICs) – are a popular investment option for participants in defined contribution plans. A stable value investment option offers a return of money invested at a predetermined interest rate.

For more information regarding this report, contact Lucian Lombardi, Assistant Vice President, LIMRA International, at 860-285-7845.