Report: Lump-Sum Distributions Hurting Future Retirement Income

July 2, 2003 ( - Of the 53.3 million workers covered by some form of retirement savings account, 39.5 million report having a lump-sum distribution option and approximately 14.3 million have used this option at least once during their working life.

However, of those who reported that they had received at least one lump-sum distribution, only 36% said that they had rolled over the entire amount of the most recent distribution into another retirement plan – a number representing 59% of the dollars distributed as lump sums. Another 48% of recipients said that they had saved at least part of the distribution in some other way, according to the Congressional Research Service (CRS) report Pension Issues: Lump-Sum Distributions and Retirement Income Security.

In 1998, the average value of these distributions was $15,400 and the median value was $5,000. The typical recipient was between 36 and 39 years old at the time of the most recent distribution. Thus, most recipients of lump sums were more than 20 years away from retirement.

Generational Hex

This relatively low total of complete rollovers is especially vexing when framed against the backdrop of the younger, more mobile workforce. A typical 25-year-old today will work for seven or more employers before reaching age 65, and thus could receive several such distributions before reaching retirement age

The problem as the CRS sees it, is that lump-sum distributions that are spent rather than rolled over into another retirement account can reduce future retirement income. If the lump-sum distributions received up to 1998 that were not rolled over had instead been rolled over into accounts that grew at the same historical rate as the Standard & Poor’s 500 (S&P 500) Index, they would have grown to a median value of $12,930 by 2002. If these distributions had been rolled over into accounts that paid the same historical rates of return as US Treasury bonds, they would have grown to a median value of $7,980 by 2002.

Taking it out even further, the CRS found that assuming an age 65 retirement, the typical individual who had received a distribution but did not roll it over into another retirement account was from 28 to 31 years away from retirement in the year that he or she received the distribution. Assuming a future average annual rate of return in the stock market of 8%, $12,930 invested for 15 years would grow to $41,000 by age 65. T his would be enough to purchase a life-long annuity that would provide income of $290 per month.

If the lump sums that were not rolled over had been rolled into an account paying the same rate of return as 30-year Treasury bonds, they would have reached a median value of $7,980 in 2002. Assuming that $7,980 was invested in bonds for 15 years at an average rate of return of 5.0%, it would grow to $16,590.This would be sufficient capital to purchase a lifetime annuity that would provide a monthly income of $117.

Immediate Need

Instead many recipients of lump-sum distributions use all or part of the distribution for current consumption rather than placing it in another retirement plan. Not surprisingly, the report found a positive correlation between the age of the participant and the likelihood that the funds would be spent on immediate consumptions.

However, the younger employees of today need to give more credence to given the current cost-of-living projections for the retirement years. According to a study conducted by the Employee Benefits Research Institute (EBRI) and the Investment Company Institute (ICI) retirees require 70% to 80% of their preretirement income to maintain their preretirement lifestyles (See Continual 401(k) Participation Pays Larger Dividends ). The report found that y ounger workers contributing to a 401(k) can expect median initial annual retirement benefits 83% to 85% of their working income.

However, most of today’s retireesrely on Social Security for the majority of their income. In 2001, nearly two-thirds (65%) of the program’s beneficiaries received more than half of their annual income from Social Security, and Social Security was the only source of income for one in five (20%) beneficiaries.

To encourage individuals to roll over these distributions into another retirement plan, Congress in 1986 enacted a10% excise tax on pre-retirement pension distributions that are not rolled over. Further, in 1992, Congress required employers to withhold for income tax payment 20% of distributions that are paid to recipients rather than rolled into another retirement plan. In 2001, Congress required that, unless the plan sponsor is otherwise directed by the participant, it must deposit distributions of $1,000 or more into an individual retirement account.