Shrinks Lump-Sum Payouts
Changes in Defined-Benefit Plans Affect Many Highly-Paid
Workers; Making Do With $200,000 Less
By Theo Francis
The Wall Street Journal
Wednesday, October 25, 2006
When Larry Korwatch began planning his retirement last winter
after three decades as a ship's engineer, his pension-plan
administrator told him he could expect to walk away with a
lump-sum payment of about $1.3 million.
That was before Congress passed sweeping pension-reform
legislation in August. Now, Mr. Korwatch has learned that his
retirement payout will be cut by about $200,000.
The reason: The new pension law changes the way companies
calculate how much to pay retirees who choose to take their
pensions in a single payout. Although many retirees opt to
receive their pensions as a monthly check, and therefore aren't
affected by the changes, the new legislation is expected to
reduce the pensions of millions of Americans as they retire in
Retirement advisers are crying foul, especially because one
change introduced by the new law is retroactive to the beginning
of 2006 and is affecting people who have already retired or plan
to do so soon. "You can't slice and dice a man's nest-egg the
year he retires without advance notice," says Joe Clark, an
Anderson, Ind., financial adviser with a client whose lump-sum
pension was reduced by the change.
The changes affect so-called defined-benefit pension plans,
which traditionally provide a monthly payment for life in
retirement, based on the retiree's pay and years of service.
Some 22 million Americans working at private-sector companies
participate in defined-benefit pension plans, about half of whom
have the option to take the benefit as a lump-sum payment.
Pension experts say most do so, though figures aren't available.
Employees can avoid the pitfalls of the new law by taking their
pension as a lifetime stream of paychecks, rather than a lump
sum. Many retirement experts recommend that as the safest
alternative because it doesn't leave retirees subject to the
risk that their investments will fare poorly or that they will
spend their assets before their deaths. But this approach can
backfire if an employer is on shaky financial ground. Some
companies, notably in the airline and steel industries, have
filed for bankruptcy in recent years and handed over their
pension plans to the federal government, resulting in smaller
payouts to some employees.
The latest pension changes come as defined-benefit plans have
come under pressure. Several companies have announced plans to
freeze their pensions this year, including
Verizon Communications Inc. and
International Business Machines Corp., preventing employees
from earning new benefits. Meanwhile, many employers
increasingly emphasize retirement savings plans, such as
401(k)s, in which employees can save and defer income taxes on
some of their pay. Many employers contribute to these accounts
The pension law made two changes that effectively reduce payouts
when a retiree takes his pension as a lump sum. Companies
calculate this by taking the monthly payment the retiree is
entitled to and then figuring how much this is worth as a lump
sum in today's dollars, making certain assumptions about life
spans and future investment returns.
Under the new law, companies starting in 2008 will be able to
assume a higher investment return, using a corporate-bond
interest rate instead of the lower Treasury-bond rate previously
used. This change produces a smaller lump sum payment, because
the higher rate represents the return an employee would have to
earn to generate the same retirement income as if he were
receiving the pension as a monthly paycheck.
This change will be phased in gradually over five years, and
people who retire in the next year will see little impact on
their payout. "It's going to mean lump sums are smaller for
everybody," says David Certner, director of legislative policy
for AARP, the seniors advocacy group.
But another change in the pension law has already begun hitting
employees, especially highly paid professionals, who have
recently retired or plan to retire soon. This change stems from
a calculation companies must make that places a cap on the
maximum amount a retiree can receive when it is converted to a
lump sum. Congress legislates the maximum size of pension
payouts because contributing to the plans offers employers
certain tax advantages.
For 2006, the biggest annual pension a person age 62 to 65 is
allowed to receive from a taxpayer-subsidized plan is $175,000.
This cap, which is lower for younger pensioners, increases each
year to account for inflation.
The change introduced by Congress affects how much this capped
annual amount is worth when companies convert it into a lump
sum. In calculating this sum, the new law requires companies to
use a higher interest rate -- 5.5%, up from a variable rate that
was below 5% most of this year -- as the assumed rate of return,
which effectively lowers the maximum allowed lump-sum payment.
That's what caused Mr. Korwatch's pension to shrink to $1.1
million. "It's frustrating," he says about the cut in his
expected payout. A co-worker "only has 21 years with the union,
and he's getting the same amount as me."
Mr. Korwatch says he's considering delaying his retirement
beyond his planned departure next month, when he turns 51, in
order to build up a bigger pension. But after some 30 years
working at sea in an arduous profession, the Alamo, Calif.,
resident had been looking forward to retiring.
The rule change won't affect many top corporate executives,
because they typically benefit from "supplemental" pensions that
make up for any benefits lost to the tax-law cap.
Retirement-industry officials have raised concerns that the rule
change affecting pension caps was made retroactive to Jan. 1,
which means that people who already took lump-sum payments this
year could be asked to return some of the money they received.
"It's terrible," says Ron Gebhardtsbauer, senior pension fellow
for the American Academy of Actuaries, a trade association.
"We're all scratching our heads and saying, 'You can't do
that.' " Mr. Gebhardtsbauer says the Jan. 1 date appears to
have been written into the legislation last year, on the
assumption that the measure would pass by the end of 2005 or
Political squabbling delayed passage of the pension bill another
eight months, but the date wasn't changed. Pension trade groups
have asked Congress to change the effective date for the
provision at the earliest to Aug. 17, the day the law was
Mr. Korwatch's pension plan intends to wait for government
guidance or corrective legislation before deciding whether to
seek money back from those who retired earlier this year, says
Allen Szymczak, who administers the plan for the Marine
Engineers' Beneficial Association. Whatever happens, "We have
to do it by the law," Mr. Szymczak says.
Another complication: Some retirees whose lump sums are capped
may be entitled to get some of the forgone benefits back as an
annuity, which is paid as a stream of income, in addition to the
lump sum, several pension experts say. However, that could
depend on the terms of the plan, they say. Mr. Szymczak says the
consultants for his union's plan haven't raised this issue.
Theo Francis at