A Cautionary Tale of Low Interest Rates with Lump Sum Distributions

Defined benefit plans can offer lump sum distributions to participants when they terminate employment. This option is common as a method for plan sponsors to lessen administrative costs and offer portable benefits. The lump sum is equal to the present value of the participant’s benefit, a defined annuity payable at a future date and continuing for the lifetime of the participant. In offering lump sums, plans can release the unpredictable future burden of longevity and plan investment risk and reduce administrative costs. However, they also open themselves to the risk of the current interest rate environment.

A qualified plan lump sum is calculated using mortality assumptions and bond-related interest rates that are prescribed by the IRS. The mortality assumption determines how long the participant is expected to live (and receive annuity payments, were the lump sum not paid). The interest rates are used to discount these future expected payments back to today’s dollars, such that the lump sum and the expected annuity stream have the same present value. The lower the interest rate used for this purpose, the higher the resulting lump sum.

Two years ago, the underlying rates were tiered from 3.33% to 4.72%. As of June 30, 2020, those rates are 0.74% to 3.32%. Depending on the age of the participant, that one-year change can represent a 18% to 94%* increase in the lump sum amount.

A plan sponsor is left with little to no room to respond when interest rates drastically drop. Legally, the plan sponsor cannot remove the lump sum option on accrued benefits, nor can they force a participant to take any form of payment over another.

Now is the time to proactively distribute small benefits for terminated participants according to the provisions of the plan if not done on a regular basis already. Plans can be written to automatically distribute benefits up to $5,000.

Please contact your IAI consultant if you would like to discuss how (and whether) to pay terminated participants lump sums.

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