I always wondered why Jimmy Stewart’s neighbors in Alfred Hitchcock’s voyeuristic classic, Rear Window, didn’t just close their windows and draw the shades. (Obviously they were much less self conscious than I am.) Of course, that would have made the film pretty dull for moviegoers and Stewart’s lead character.
A Window Left Open
Open windows are much more compelling, which is probably why retirement providers seem so interested in a recently announced inaction by the IRS. Notice 2019-18 clarifies that the IRS no longer plans to actively block the offering of temporary lump sum “windows” to pensioners currently receiving monthly benefits from defined benefit (DB) plans.
(The regulatory trail of breadcrumbs is a bit more complex than this, but the end result is that pensioner windows are now being tacitly accepted. This is subtly different than an explicit approval, so interested sponsors are strongly advised to consult counsel.)
Windows for terminated vested participants (those no longer employed but not yet collecting their pensions) have been wide open for years, and are a common method for cost effectively transferring risk out of DB plans. The ability to include current pensioners, however, is a relatively new concept for most. And the IRS’ refusal to close the blinds has attracted the gaze of many sponsors and consultants looking to reduce risk at a reasonable price.
Cost and Certainty
Cost is the primary reason why sponsors offer lump sums to terminated vested participants instead of buying annuities. Depending on the plan and population, annuities for terminated vested participants can cost 5 to 20 percent more than paying lump sums. This is because insurers charge more to cover the uncertainties of future interest rates, mortality, and option elections of the group.
But payments to retirees are much more certain than terminated vesteds. Benefit amounts and elected options are known, and future life expectancy is shorter. With better data, insurers don’t need to include as much padding in retiree annuity pricing to cover their risk. So pensioner lump sums could save a bit of cash, but the amount may be less than hoped.
Worth the Trouble?
Stewart’s peeping taught him a lot (without even having to change out of his pajamas), but the trouble his curiosity eventually caused probably had him wishing the windows had never been left open. Sponsors looking to cash out pensioners may feel the same way once they realize some of the details.
While this new tool for managing pension risk may be a good fit for some, there are a number of reasons why opening a retiree window may be less than ideal.
- Antiselection: Being further along in their life journeys, retirees have a better understanding of their own mortality expectancies. Those expecting to live shorter than average will be more likely to take the lump sum, while those who feel poised for a long run will probably refuse the offer and keep their lifetime income. Insurers would be foolish to ignore previous lump sums when pricing annuities for groups of retirees, so the end result could be higher rather than lower costs overall.
- Administration: Unlike annuity purchases which can be executed by sponsors unilaterally, lump sums may only be offered, not forced. Election packages requires calculations, mailings, and processing, all of which add costs that offset savings. And take-up rates may disappoint. The average term vested window gets 50-70 percent acceptance. Retirees would likely accept the offer at lower rates since they are already accustomed to the regular income.
- Ethical Questions: It’s natural to ask whether interrupting the lifetime income payments to older people is a good idea. A lump sum offer is a complicated proposition with many variables to consider, and can be a difficult choice even for savvy participants and their financial advisors. Embarking on a process that introduces opportunities for retirees to make mistakes, or be misled or exploited by others, is a heavy question for plan fiduciaries to weigh.
The market will ultimately determine whether retiree lump sums become popular or not, and I would never discourage a sponsor from learning more about them. But my gut tells me that most will weigh the pros and cons, and decide that opening the retiree window could bring more trouble than it’s worth.
Jimmy Stewart would agree. I mean, Raymond Burr would’ve killed him at the end if it weren’t for those giant flash bulbs!
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA), who does a pretty good Jimmy Stewart impersonation if he says so himself.
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