Congress has fallen in love with cute names for legislation. It seems that lawmakers find it necessary to create catchy titles or to select words whose initial letters make a convenient acronym, ranging from the serious USA PATRIOT Act (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism) to the ironic ENRON Act (Electricity Needs Rules and Oversight Now). In response to this trend, a part-time political pundit named David Weinberger has promised in his mock presidential campaign platform to lobby for passage of the SHANANA Act -- Stop the Hilarious Absurdity: No Acronyms Naming Anything.
Now, there's nothing wrong with memorable names for dry, lengthy bills. It's fair, however, to draw a line at the point where the name of a piece of legislation becomes misleading. For instance, someone reading about the recently passed Pension Protection Act would probably conclude that the law does something to protect them and their pensions. Indeed, a look at the general provisions of the law reveals several items that help workers improve their ability to plan for their retirement. However, by making just a minor change that many would fail to notice, the law puts a major dent in the pensions of many workers.
The lump-sum lottery
Although defined-benefit pension plans have become less popular as participation in defined-contribution plans like 401(k) plans has increased, some workers still have pensions as part of their benefits package. Under a defined-benefit plan, workers are entitled to a certain monthly pension benefit upon retirement. In calculating the monthly payment, plans take several factors into account, including the length of time a worker was employed and the salary amounts the worker earned during employment.
If you've ever read about big lottery prizes, you probably know that winners usually have two choices: They can either take the total amount of the prize in installments over a period of years, or they can take a single, smaller payment up front. Many defined-benefit plans give employees a similar choice when they retire; workers can choose either monthly payments extending into retirement or a single payment called a lump-sum distribution. For those retirees who choose to take their pension in a lump sum, that payment effectively ends their relationship with their former employer. At that point, it's up to the retiree to manage the lump sum and invest it in a way that will support the retiree's needs.
Arcane actuarial assumptions
So you might ask: How do they figure out what the lump sum should be? To determine the appropriate amount for a lump-sum distribution, you need to know three things: what your monthly payment would be, what your life expectancy is, and what interest rate you must use to calculate the present value of future payments. Life expectancy can be calculated from appropriate mortality tables. Before the Pension Protection Act was passed, the interest rate used for discounting future payments was based on the 30-year Treasury bond.
Taking an example, assume that you're a 65-year-old who is entitled to a pension payment of $2,000 each month. Also assume that your life expectancy is 20 years, which is reasonably close to the result given by the mortality tables. If you retired now, you could choose either to take your $2,000 monthly or to take a lump-sum distribution in a single payment now. To calculate the amount of the lump sum, your employer would take the 240 monthly payments you would receive if you lived your full life expectancy and discount the future payments by the appropriate interest rate. If this rate were 5% -- again, fairly close to current 30-year Treasury bond rate -- then the value of your lump sum would be a bit more than $300,000.
Who does the new law protect?
The Pension Protection Act changes the interest rate used for discounting purposes. Instead of using a rate based on the 30-year Treasury bond, it allows employers to use a rate based on corporate bond yields. Because even high-quality corporate bonds involve a higher degree of default risk, their bonds tend to have higher yields than Treasury bonds of similar maturity.
By using a higher interest rate for discounting purposes, employers are able to reduce the amounts they offer employees for lump-sum distributions. Currently, the spread between Treasury bonds and corporate bonds is about 1%. Using the previous example, the new legislation might call for your employer to use a 6% rate to determine the value of your lump sum. Using 6% instead of 5% as the discount factor reduces your lump-sum distribution to less than $280,000.
Lawmakers cite artificially low Treasury rates as being an unfair burden on employers that inflates the amount they have to pay employees in lump-sum distributions. By using corporate bonds to determine lump-sum amounts, they argue, employers bear a fairer share of their obligation to their employees. Furthermore, changes in the mortality tables that increase life expectancies for certain employees may offset the decreases resulting from using a higher interest rate.
It's true that many employers need some protection from their huge pension liabilities. For big companies like Raytheon
Consider all your options
The recent changes to the laws governing pensions are just the latest example of why it's important to think carefully about the choices you have as you enter retirement. It's complicated enough to figure out all the rules that apply even without worrying about how they might change over time. Before you make a decision you might later regret, find out everything you need to know to make an informed choice that will maximize the benefits you've earned over a lifetime of hard work.
Do you need help working through all the complex rules governing pensions? Check out the Fool's Rule Your Retirement newsletter. Fool analyst Robert Brokamp guides you through the maze of regulations to help you avoid mistakes and make the best decisions to protect and enhance your retirement. Sign up for a free 30-day trial today.
Fool contributor Dan Caplinger doesn't have to worry about lump-sum reductions, since nothing from nothing leaves nothing. He doesn't hold positions in any of the companies mentioned in this article. The Fool's disclosure policy does its work even without a catchy title.