Barry’s Pickings: Retiree Lump Sums—a (Non-Hysterical) User’s Guide

Michael Barry, president of O3 Plan Advisory Services LLC, discusses when taking a lump-sum payment instead of continuing an annuity is—and is not—a good idea for retirees.
Art by Joe Ciardiello

Art by Joe Ciardiello

There has been significant coverage of IRS’s recent Notice announcing that it no longer intends to amend required minimum distribution (RMD) regulations to prohibit defined benefit (DB) plans from paying lump sums to retirees.

The message in the news seems to be that this—permitting the payment of retiree lump sums—is a very bad idea. That “annuities are good and lump sums are bad.” That message is way over-the-top and disingenuous and as a result does a dis-service to many individual retirees for whom a lump-sum offer may in fact be a financial windfall.

At 2013 ERISA Advisory Council hearings on “Private Sector Pension De-risking and Participant Protections,” then Pension Benefit Guaranty Corporation (PBGC) Director Joshua Gotbaum “likened pension plan lump-sum cash-outs to cigarettes: legal, liked, and bad for you.” On the other hand, the only retiree witnesses at those hearings—Jack Cohen, testifying on behalf of the Association of BellTel Retirees—told the Council that he believes “retirees should be permitted to make their own decisions about whether to accept a lump-sum offer.”

Let’s get one issue out of the way at the top. No one is talking about forcing retirees to take a lump sum. What policymakers like Gotbaum, and participant advocacy groups like the Pension Rights Center, are concerned about is that participants (like Cohen) will want to take lump sums, even though, like smoking cigarettes, it is bad for them. Thus, you can think of this effort as of piece with, for instance, New York Mayor Michael Bloomberg’s attempt to ban “big” soft drinks. Think Nanny State.

If you’re a smoker, you probably should take a lump sum

This “lump sums are like smoking” argument is (unintentionally) ironic: if you are a smoker, taking a lump sum—contrary to Gotbaum et. al.—may be a really good idea, given your reduced life expectancy.

I have no dog in this hunt. I think there are good arguments on both sides.

I think if all you care about is retirement income, then an (efficiently priced) annuity—like the one typically provided by a DB plan—is an ideal solution. Policymakers, sponsors, annuity providers and wonks have all been puzzled as to why DB plan participants often prefer lump sums (when they are offered), and there is little demand for an annuity option in DC plans. Economists call this the “annuity puzzle.”

Reasons not to annuitize

In a written statement submitted to the 2018 ERISA Advisory Council (this issue just never goes away), Sarah Holden, Senior Director, Retirement and Investor Research, and Shannon Salinas, Assistant General Counsel ─ Retirement Policy, of the Investment Company Institute, neatly summarized what is left out of this view that “lump sums are bad for you (like cigarettes).” They pointed out that (1950s) research showing that “rational consumers should use all of their life savings to purchase an annuity at retirement” does not take into account a number of critical factors:

The [“rational retirees should buy annuities”] models do not account for the fact that individuals have other annuitized resources, such as Social Security and defined benefit (DB) pensions. Nor do they incorporate uncertainty about future consumption needs, which would cause individuals to keep a portion of wealth liquid in case of unexpected need. Further, the models typically focus on single individuals, whereas married couples get much less insurance value from purchasing an annuity. In addition, the prediction of full annuitization relies on the assumption that individuals place no value on resources passed on to their heirs, whereas evidence suggests that a large portion of the population desires to leave bequests.

More recent research, by Felix Reichling of the Congressional Budget Office (CBO) and Kent Smetters of the Wharton School, has shown that the “annuities are good for you” conclusion is in fact “driven by assumptions embedded in the model. … If, instead, it is assumed that individuals learn new information about their health and mortality risk over time, and that adverse health events both increase mortality risk and are costly (in the form of lower income or higher out-of-pocket expenses), then the result that retirees should fully annuitize disappears.”

I would add one other issue. Media coverage (e.g., CNN’s A losing deal for retirees) has included the statement “Retirees who tried to reinvest the lump-sum payments would almost inevitably lose out—especially women, who tend to live longer than men and are more likely to run out of money in retirement.” (Emphasis added.) If this statement is true—and I would guess that in many cases it is—it is partly because the lump-sum value of a pension paid out of a plan is determined using unisex actuarial tables, which understate women’s life expectancy and the lump-sum value of a woman’s pension. To point out the obvious, it is (perhaps significantly) less true for men, because those same unisex tables overstate men’s life expectancy and the lump-sum value of their pensions.

When I say that those denouncing IRS’s Notice as bad for retirees are disingenuous, I mean that they are taking no account the foregoing—it would seem to me obvious—points.

Factors to consider

Let me bullet out what, in my view, is the bottom line on this issue, from the individual participant’s point of view:

Life expectancy and annuitizationIf you have no reason to believe that your life expectancy is below average, and you depend on your pension to meet basic needs, taking a lump sum is generally a very bad idea. An annuity will provide you with a greater lifetime income than pretty much any other option and is obviously better than self-insuring against longevity.

If your health is compromised—if you have good reason to believe your life expectancy is lower than average—you may be better off taking a lump sum. In certain cases, e.g., where the doctors have given you six months to live, you will almost certainly be better off.

Married couples will have a more complicated life expectancy issue to evaluate. Married individuals (and families) are able to provide their own pooling of longevity risk (between spouses and between generations). That is why, as noted above, they get less insurance value from an annuity. It is, however, likely that one of the two spouses will live to a very old age.

Delaying Social SecurityTaking a lump sum may enable you to delay Social Security annuitization. There is a nearly universal agreement that delaying your Social Security start date (e.g., to age 70) is, for most individuals, the best annuity deal on offer right now. If taking a lump sum will permit you to delay it, then the lump sum may be a good idea.

Alternative resources and objectivesIf you have adequate alternative annuity resources to meet your basic needs or if you want to, e.g., dedicate part of your retirement assets to a legacy, you may want to consider taking a lump sum. You should, however, consider that, if you (rationally) believe you have a longer-than-average life expectancy, keeping the annuity may be a better financial bet than investing in the stock market. In this regard, individuals should consider the bias introduced into this analysis by the plan’s use of unisex tables: men will have shorter-than-average life expectancies and women will have longer-than-average life expectancies than the life-expectancy assumptions the plan uses to calculate the lump sum.

Exposure to equities pro and conYou may want exposure to the equity markets, and you can’t get that unless you take a lump sum. Individuals thinking about taking a lump sum should, however, consider whether they will be able to efficiently invest it. In the typical 401(k) plan, there often are tools in place—target date funds, defaults, and a curated menu of institutionally priced funds—that frame participant decisions and may produce better investment outcomes than may be achieved by an individual retiree receiving a lump sum that he rolls into an IRA.

A preference for flexibilityFinally, you may want spending flexibility in retirement—for a wide variety reasons, including concerns about risk and simple spending preferences. A lump sum will provide more spending flexibility than a life annuity.

Evaluating these issues isn’t easy. There are a number of factors that may be relevant—I’m not pretending to have discussed them all. If you have access to competent assistance with financial decisions, use it. There’s a lot of judgment required in making this one.

The sponsor’s view

I’ve written the foregoing from the retiree’s point of view. There are, however, a number of reasons why retirement plan sponsors might not want to implement a retiree lump-sum program. Some to consider are: The savings—versus buying an annuity in a risk transfer transaction—isn’t as great as it is for non-retiree lump sums.  There’s a hidden adverse selection cost, which is exacerbated by the unisex mortality table issue. And offering lump sums to some older annuitants may present consent/fiduciary issues.

Just because the press is saying that lump sums are (as CNN put it) a “losing deal for retirees,” doesn’t mean they are a win for sponsors.


Michael Barry is president of O3 Plan Advisory Services LLC, and author of the new book, “Retirement Savings Policy: Past, Present, and Future.” He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly about retirement plan and policy issues.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services (ISS) or its affiliates.