Rather than receiving a monthly check upon retirement (annuity payments), many people think of taking out a lump sum distribution (a one time distribution) of their retirement assets. If you do decide to take out a lump sum distribution of your 401k assets, consider the Pension Protection Act of 2006 which could severely reduce the amount of money you actually withdraw from your lump sum payment.
Why would Retirees take out a Lump Sum Distribution?
A monthly check that covers your living expenses and gives you some savings thereafter always sounds good right? You can just check your mail every morning for those checks to roll in, or check your bank account for a credit balance to appear. However, other retirees decide to take out a lump sum distribution because of some of these reasons:
i) The employer may face tough economic times ahead of the future and may not be financially stable, or even go bankrupt. In any case, the Pension Benefit Guaranty Corporation (PBGC) makes sure that you receive your pension benefits even if your employer goes bankrupt. However, in most of the cases, you will end up with a smaller amount of your pension benefit than you thought, because of the charges and expenses incurred by the PBGC. You might therefore have lesser money upon retirement, and possibly not enough money to survive through retirement!
ii) If you want to open your own business upon retirement, a lump sum distribution of your 401k assets is the best choice for most retirees.
iii) The retiree thinks he is a better investor than the pension managers and decides to take the investment into his own hands.
How does the Pension Protection Act of 2006 Affect Lump Sum Distributions?
The Pension Protection Act of 2006 affects lump-sum 401k distributions in 2 ways:
i) It alters the way corporations calculate the amount of pension benefit for their employees.
ii) It caps out the amount of lump sum distribution you can take out.
Can you give me an example of how the pension benefit is calculated?
Upon retirement, your employer will use your pension benefit or annuity payments to calculate the present value of your lump sum distribution. The calculation will factor in your life expectancy rates and future return on investments. Here’s an example:
Monthly Payments Upon Retirement: | $2500 per month |
Life Expectancy: | 25 years |
Interest Rate: | 6% |
Present Value of Lump Sum Distribution: | = $383,501 |
Therefore, if you are eligible to receive $2500 per month for the next 25 years at an interest rate of 6%, using Financial Analyst BAII Plus calculator, the present value of your lump sum distribution is $383,501.
Let’s consider another scenario where the interest rate achieved on the investment is higher, lets make it 8%.
Monthly Payments Upon Retirement: | $2500 per month |
Life Expectancy: | 25 years |
Interest Rate: | 8% |
Present Value of Lump Sum Distribution: | = $320,243 |
As you can see from the above example, if your pension manager can get you higher interest rates, you will receive a lower lump sum payment. Therefore, the mathematical relationship is:
Lower Interest Rate = Higher Present Lump Sum Payment Higher Interest Rate = Lower Present Lump Sum Payment |
New Rules of the Pension Protection Act of 2006
- Starting from 2006, the highest one time lump sum payment that a 401k retirement saver (between 62 to 65) can receive is $175,000. This limit is lowered for younger people.
- Starting from 2008, the assumptions (such as interest rate, life expectancy & rates of return on investment) that we used will change from the 30 year Treasury bond rate to the corporate bond interest rates. Since corporate bonds have higher risk than treasury bonds, their interest rates and yields are consequently higher. Therefore, the lump sum payments that you receive will be even lower.