What Happens When You Show Them the Money?: Lump Sum Distributions, Retirement Income Security, and Public Policy

Final Report06750-003What Happens When You Show Themthe Money?: Lump-Sum Distributions,Retirement Income Security, andPublic PolicybyLeonard E. BurmanDepartment of TreasuryNorma B. CoeDepartment of TreasuryWilliam G. GaleThe Brookings Institution November 1999This research was funded by the Pension and Welfare Benefits Administration of the U.S.Department of Labor (Contract No.: J-9-P-7-0044). The authors would like to thank MichaelDoran, James Cilke, Lowell Dworin, Paul Smith, Eric Toder, Cori Uccello and Sheila Zedlewskifor helpful comments, and Tats Kanenari for research assistance. The nonpartisan UrbanInstitute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the TreasuryDepartment, the Administration, the staff, officers or trustees of the Brookings Institution, or theUrban Institute, its trustees, or its funders. THE URBAN INSTITUTE 2100 M STREET, N.W. / WASHINGTON D.C. 20037 / (202) 833-7200 ABSTRACTWe examine pre-retirement lump-sum distributions from pension plans, which havegrown significantly in recent years. Most LSD recipients do not roll over the funds into qualifiedaccounts, but the likelihood of rollover rises for larger distributions. We find that tax penaltiesimposed in 1986 on non-rollovers by people younger than 55 raised the likelihood of rolloversamong this group, but had less effect on the likelihood that such households saved the funds,where saving includes investing in taxable assets and paying off debt. Simple calculationsindicate that cash-outs reduce annual retirement income by $1,000 to $3,000. These calculationsalmost surely overstate the pension loss. Nevertheless, pension loss may be quite importantamong the affected households, who are likely to have accumulated less retirement wealth than average. 1I. IntroductionA major objective of public policy toward pensions is to ensure adequate retirementincome for as many workers as possible. The best way to achieve this goal, however, is oftenuncertain. In this paper, we examine the role of one aspect of pension policy: the tax treatmentof lump-sum distributions that are taken from pension balances before a worker reachesretirement age. Upon changing jobs, many workers can choose between leaving their existing,vested pension balances in the pension plan they had been enrolled in, or taking the funds as alump-sum distribution (LSD). If taken as an LSD, the funds may be "rolled over" to anotherqualified plan (typically, either the defined contribution plan at the worker's new employer or anIndividual Retirement Account), or may be cashed out and used for some other purpose.Policy currently discourages workers from cashing out their pension balances beforeretirement age. Funds that are cashed out are subject to taxation as ordinary income, as are allpension benefits. In addition, the Tax Reform Act of 1986 required that funds that are cashed outare also subject to a 10 percent penalty tax depending on the workerZs age. The penalty taxapplies to workers up to age 59O if the distribution is taken prior to job termination, and toworkers up to age 55 if the distribution is taken as part of a job termination. Since 1993, theemployer must assess a withholding tax of 20 percent on any cash distribution not transferredinto a qualified account. Also, employers are required to offer departing employees the option ofdirectly transferring lump-sum and certain other distributions into another qualified retirementplan or IRA. Despite these tax considerations, most workers who receive lump-sum distributions cashout the funds, thus potentially sacrificing future retirement income in exchange for currentexpenditures. Lump-sum distributions are sizable and have grown rapidly in recent years. 2Moreover, a variety of trends, including the shift toward defined contribution plans--where LSDsare more prevalent--suggest that distributions will become even larger in the future. These facts,combined with projections of increased life spans and concerns about the adequacy ofhouseholdsZ saving for retirement, raise a number of important positive and normative questionsfor researchers and policy makers. What is the impact of penalty and withholding taxes onrollover behavior, retirement wealth accumulation, and broader measures of saving? Do theseeffects differ across demographic groups who also vary in their preparation for retirement? Doesthe availability of early, albeit penalized, lump-sum distributions increase pension participationby making pensions more attractive to workers--because the money is portable and accessible fornon-retirement purposes? How do LSD rules interact with withdrawal rules for othertax-preferred saving incentives? How should LSD rules be designed?This paper explores some of these issues and is organized as follows. Section II reviewsprevious research findings, identifying consensus fin