In the pension world, there are two basic types of pension plans: (1) defined contribution (DC) (e.g., 401k) which establish an account for each participant, provide a benefit based on the investment performance of assets allocated to the account, and pay the benefit in a lump sum form (i.e., the account balance), and (2) defined benefit (DB) which provide a benefit based on a formula defined in the plan, but typically provide only annuity benefits, although some DB plans DO provide a lump sum option.
By law, lump sums paid from a DB plan must be no less than the present value of the annuity under the plan commencing at normal retirement age. Further, the present value must be determined using the “applicable interest rate” and “applicable mortality table” set forth in Internal Revenue Code §417(e) and its governing regulatory authority. The proscribed mortality table, set each year by the Secretary of the Treasury, changes little from one year to another. Therefore, any change in the applicable mortality table has relatively little impact on the lump sum. The “applicable interest rate,” however, is another story.
The “applicable interest rate” is a actually a set of three “segment rates” derived from average monthly corporate bond yields published by the IRS. So, for example, the August 2022 segment rates were 3.79%, 4.62%, and 4.69% for benefits payable respectively within 5 years, 15 years, and thereafter of the lump sum payment date.
There is an inverse relationship between the interest rate(s) used to present-value an annuity and the resultant lump sum. The higher the rate(s) utilized, the smaller the lump sum; the lower the rate(s) utilized, the larger the lump sum. Therefore, if you have taken a lump sum recently, or are planning on doing so, soon, you should want to make sure your lump sum is/was computed using the lowest legally required interest rate(s).
Most DB plans (other than multiemployer plans) are calendar year plans. Most also select the “applicable interest rate” from August, September, October, or November of the prior plan year to compute lump sums payable in the current plan year. This is perfectly legal. But in an increasing interest-rate environment, retiring in the following year can result in a devastating reduction to your lump sum, as compared to the lump sum you could have received by retiring in the current year.
Here’s a real life example: Client was in a DB plan and wanted to retire by the end of 2022 and take his pension in a lump sum form. The plan is a calendar year plan and uses the segment rates from August of the prior plan year to compute lump sums payable in the current plan year.
In September 2022, Client told his supervisor he would retire by January 1, 2023. The very next day, the plan administrator sent Client a document stating that, if he retired on December 1, 2022, his lump sum would equal $483,000, but if he retired on January 1, 2023, his lump sum would equal $$396,600–$86,400 less than if he retired one month earlier! Why? Because the August 2022 segment rates used to compute lump sums payable in 2023 were considerably higher than the August 2021 segment rates used to compute lump sums payable in 2022. The August 2022 segment rates were 3.79%, 4.62%, and 4.69%, while the August 2021 segment rates were 0.65%. 2.50%, and 3.12%.
Naturally, Client attempted to move his retirement date up by one month, to December 1, 2022, but was not permitted to do so. So, he received the smaller lump sum amount.
But Client was not previously informed that in an increasing interest rate environment, the lump sum may be significantly reduced if it is taken in the following year rather than in the current year. This is information that should have been disclosed in the plan’s summary plan materials, but was not. Accordingly, Client has a claim for violation of the disclosure rules under the Employee Retirement Income Security Act.
If you believe your lump sum was or will be understated for similar non-disclosure reasons, contact Ms. Cantarella so she can check it out for you. [See contact information below.]
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