Pension Payouts Are Shrinking

Retirees who planned to take the money and run may find themselves with less than they expected. New rules that take effect in 2008 change the way pension plans calculate lump-sum distributions.

The impact will be relatively small this year. But the reduction in future payouts, particularly for younger workers, could be substantial as the new formula is fully phased in over the next five years. And that could make the alternative -- regular monthly pension checks -- far more attractive.

Basic math. Traditional pension benefits are based on your years of service and average pay. If your plan allows a lump-sum distribution (about half of all pension plans do), the calculation to transform monthly payments into one tidy amount factors in your life expectancy and prevailing interest rates. When interest rates are low, you get a bigger lump sum. That's because, with a lower return, it takes a bigger pot of money to generate the same amount of income you'd get with a lifetime of monthly payments. But when interest rates are high, your lump sum is smaller.

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Until last year, pension plans used the 30-year Treasury-bond yield to calculate lump sums. Critics argued, however, that Treasury rates, which have been at historic lows compared with other interest rates, resulted in inflated lump sums -- which, in turn, encouraged workers to choose single payouts instead of lifetime benefits (and cost pension plans a lot of extra money). When given a choice, more than 70% of workers choose a lump sum instead of a monthly pension, according to the Vanguard Center for Retirement Research.

Starting this year, lump-sum calculations will be based on a new formula, which gradually replaces the Treasury-bond rate with a higher, blended rate based on corporate bonds. As a result, retirees will get substantially smaller lump sums by the time the new formula is fully phased in.

Let's say you're eligible for a $12,000-a-year pension at age 65, and you elect to take a lump sum this year at age 60. Under the new rules, your payout would shrink by less than 1% compared with what you would have received under the old rules, according to an analysis by the Congressional Research Service (CRS).

Compare Lump Sum Calculations

Let's assume you're entitled to a $12,000-per-year traditional pension at age 65. Here's how new interest-rate calculations would reduce the value of that pension if you elected to take it as a lump sum.

If you elect to take your distribution at age 55 or 50, you could see your lump sum reduced by about 3% this year from what it would have been. But if the interest rates based on the new formula were fully in effect, the CRS analysis shows a much greater reduction in the lump-sum payout: about 12% if you collect at age 60, 21% at age 55, and 25% at age 50.

Assuming you continue to work and accrue pension benefits, your lump sum at retirement will probably be bigger than it would be today, but not as big as it might have been under the old rules, says Heidi Rackley, a principal with the Mercer consulting firm. If, however, your pension is frozen (meaning you keep the benefits you have already accrued but do not earn new benefits), you may actually see your final lump sum decline, says Rackley.

What to do? If you are nearing retirement, ask your benefits department to calculate your lump sum for both 2008 and 2009. If interest rates remain about the same, the lump sum may be higher if you retire by year-end, before the next stage of the new interest-rate formula kicks in, says Rackley. If you're planning to switch jobs, you might want to take a lump sum and roll it into an IRA (you can access your pension benefits only when you quit or retire).

But it's important to ask about the details of your company's plan, cautions Alan Glickstein, a senior consultant with Watson Wyatt Worldwide. The new calculation rules set minimum standards. Your plan may be more generous and might include a variation, such as an early-retirement subsidy, that could affect your decision.