IRS clamp down on lump sum cashouts for retirees; affirm commitment to lifetime retirement income

On July 9, the IRS issued a notice that they no longer intend to permit lump sum cashouts of pension benefits for retirees. This notice will not directly affect cashouts for terminated vested participants (whose benefits have not commenced payment.) Although the notice may have come as a surprise to many, there have been signs of disapproval for some time.  The notice can be seen as an affirmation of the regulators’ commitment to ensuring that the retirement system is focused on the provision of lifetime retirement income, not simply on the accumulation of wealth.

“They are legal, many people like them, and they are bad for you”

The statement above, likening lump sum cashouts for retirees to cigarettes, was made in 2014 to the DOL’s ERISA Advisory Council by then-Director of the PBGC, Josh Gotbaum. It sums up the sentiment which lies behind the IRS notice. Cashout programs have been under close scrutiny, and a GAO report issued in January recommended stronger disclosure around cashout programs (whether for current retirees or for terminated vested participants.) The IRS notice goes a step further.

The notice means that, once a pension benefit has started to be paid, it will no longer be possible in most circumstances to cash it out for a lump sum. This prohibition is cut from the same cloth as efforts within the Defined Contribution system to facilitate the provision of lifetime retirement income. Indeed, the fact that DB plans generally provide lifetime income, while DC plans generally do not, is seen as a major point in favor of DB.

A relatively recent development

Lump sum cashouts for retirees are less common than cashouts for terminated vested participants. They were not widespread before moves in 2012 by GM and Ford, which resulted in some $7bn-$8bn of payments. Since then, some half a dozen other major plans have taken similar steps.

The notice is unlikely to be welcomed by those plan sponsors who had been planning a retiree lump sum window but had not taken any concrete steps in that direction. (There are some grandfathering provisions for lump sum programs that were already in train at the time of the notice.) With the removal of this option, the only remaining means of capitalizing retiree liabilities is through pension buyouts (i.e. the purchase of annuities from an insurance company), which tend to cost more than lump sum cashouts. However, it does at least point to a clear vision of what the retirement system is intended to be: a vehicle for the provision of lifetime retirement income.