Members back cash pay-outs
Nearly nine out of 10 members of pension plans would choose to take a lump sum if it was available, according to a Watson Wyatt Worldwide survey carried out in 1998.
There are some strong attractions of lump sums compared with annuities. One is flexibility. People can spend their lump sum as they wish, even using it to buy an annuity. They also have complete control over the cash.
The drawbacks are that they may not be good value for money if they are gained by commuting a defined benefit pension and they may not be enough to cover retirement needs.
It is this that worries governments, who fear that if people take lump sums they will spend them not wisely but too well and then fall back on the state’s social security system.
Governments have a number of instruments at their disposal to guard against this, and tax policy is perhaps the most effective. The popularity and availability of lump sums as a retirement benefit option in different European countries is largely a reflection of their fiscal treatment.
The best example of this is Belgium, which offers a favourable tax basis for people who choose to take their pension benefits as a lump sum.
Before 1985 most occupational scheme benefits were paid in the form of annuities. Since then, however, most plans switched to lump sums , although a certain number of schemes are still paying annuities
Since then, there have been strong tax incentives to choose lump sums. In their report ‘Paying Out Pensions’ Mirko Cardinale, Alec Findlater and Mike Orszag of Watson Wyatt noted that “since 1985 there has been a strong tax advantage to lump sums. Lump sums are subject to a 16.5% tax rate (reduced to 10% for contributions paid after 1993) when individuals reach the age of 60 on the theoretical capital built up, a notional amount calculated by applying fixed capitalisation rates to the contributions paid.
“Annuities on the other hand are subject to income tax and the marginal tax rate in Belgium is 55%.”
They suggested that the conservatism of employers was the main reason why company schemes are still paying out annuities. “Employees would like to be able to take out lump sums , but companies tend to be reluctant because of the extra return needed on the schemes assts to pay benefits in the form of lump sums,” the report said.
The tax position created a situation where the pension plans were compelled to act as annuity providers after members had taken out their benefits in the form of lump sums, the report noted. “In other words, under some conditions, member of pension plans will be able to take out benefits in the form of a lump sum, settle their debt with the tax office, and then come back to the pension plan and convert the capital into a tax free annuity.”
This situation is now changing. New legislation to reform the Belgian second pillar pension system, the WAP/LPC law (Wet op Aanvullende Pensioenen, Loi sur Pensions Complémentaires) has been designed to, among other things, harmonise the tax treatment of annuities and lump sums.
The WAP/LPC law came into force in 2004. However, employers were given three years to amend their plan rules to comply with the legislation.
Under the new law, pension annuities will be taxed in the same manner as lump sums. The law also introduces an annuity option. Pension plans that provide a lump sum at retirement must offer participants the option of converting into an annuity, at a rate set by regulation. To encourage retirees to take the annuity option, the taxation of pensions and lump sum distributions has to a large extent been harmonized.
Yet an anomaly remains. The third pillar, personal pension system still favours lump sums. In their paper on the reform of the Belgian pension system , Hans Peeters, Veerle Van Gestel, Gerhard Gieselink, Jos Berghman, and Bea Van Buggenhout of the Katholic University of Leuven Belgium argue that harmonisation of the tax treatment of annuities and lump sums should be extended to third pillar: “The social objective of maintaining one’s income after retirement is difficult to reconcile with the fact that the majority of third pillar pensions are paid out in the form of a lump sum. If safeguarding a standard of living is the reason for granting fiscal benefits, then it is logical that those benefits should only be made available if the payment takes the form of an annuity,” they say.
“In the new act on supplementary pensions, an effort has been made to ensure that future second-pillar payments are made in the form of an annuity. If it is nevertheless considered necessary to maintain the fiscal benefits of savings-based pensions and individual life insurance policies, surely a similar initiative could be taken within the third pensions pillar?”
They suggest that the government’s tax policy in respect of lump sum pension payments does not square with its attitude to lump sums generally. “Based on the reasoning that a one-off payment does not constitute a fixed and regular supplement to pensions, lump sum payments are not seen as a form of social security. The fiscal benefits linked to these schemes, however, imply that the government is treating this as part of social security or social protection.”
In Germany, pension reforms have militated against lump sums in both second and third pillar pension systems. In the second pillar, no tax free lump sum is available for the new Pensionsfonds or the ‘salary sacrifice’ pensions created following the 2001 Riester reforms. Accumulated money must be used to either buy an annuity or an income drawdown contract combined with the purchase of an annuity at age 85.
Similarly with the third pillar Riester personal pensions, money must be used to either buy an annuity or an income drawdown contract. No tax-free lump sum is permitted.
New uniform taxation rules for contributions to direct insurance, Pensionskassen and Pensionsfonds have also had an impact on lump sum pensions, and have reduced their attraction to employers and employees.
Under the new rules, direct insurance - one of the five second pillar options - are treated for tax purposes in the same way as Pensionskassen and Pensionsfonds.
This means that contributions to insurance plans that provide lump sum payments are now fully taxable, pushing up the cost of the scheme either for the employer or the employee.
The reform has also tightened restrictions on the settlement of vested pension entitlements at the end of employment. In general, lump sum cash outs of pension entitlements are no longer possible.
In the past, German companies have been able to cash out pensions if they are below a certain amount to reduce the pension plan’s administrative costs. Now they can only do so if they amend the pension plan rules by stating explicitly that only pension entitlements below a specific amount will be paid as a lump sum and all other benefits will be paid as annuities.
Reducing the availability of lump sums may ensure a more sustainable pension system but what effect does it have on pensions coverage? Does the removal of the lump sum option discourage people from becoming members of supplementary pension schemes?
In a report on the structure benefit options at retirement for Ireland’s Pensions Board, Philip Shier and Linda Nally of Hewitt Associates argue that lump sum is an important option within the range of retirement options available, and that removing it or discriminating against it through tax policy would risk reducing pensions coverage.
DB schemes in Ireland may offer a lump sum in addition to the pension, or members may - as in the UK - have the option to exchange part of their income for life for a cash lump sum.
Shier and Nally say that members of DB schemes, faced with the decision whether to surrender pension for a cash sum, if this is an option, or to retain the full level of pension, will choose the lump sum.
“We believe that in the vast majority of cases, retirees take a lump sum at retirement, usually at the maximum level permitted by revenue or under the rules of the scheme, if more restrictive. This tends to be the case even where the terms for exchange are not particularly generous, which would be the case for most schemes at present, at least by comparison with annuity rates. Those who commute may also be giving up the prospect of future discretionary increases in pensions.”
Lump sums are tax free, yet they suggest that tax is not necessarily the deciding factor influencing the decision to take a lump sum. “While it is clear that the tax free status of the lump sum is an attraction, it is likely that commutation would be selected by a large number of people even if the lump sum payment were taxed in the same way as pensions,” they say.
People choose to take lump sums to pay off loans, and make significant once-off purchases, they say The choice is also driven by the belief that ” a bird in the hand is worth two in the bush” and that the cash is more useful now than spread over a period in the future.
Removing the tax advantage of lump sums might not dent their popularity, Shier and Nally suggest. “Fiscal incentives are bound to bias the options chosen and at present the ability to take tax free cash encourages individuals to select this option. It may be that this would still be the case if the tax treatment of pension and lump sum were neutral.
Tax policy does, however, indirectly affect choice, they say. “The perceived tax efficiency of different retirement options can have a significant impact on both pension coverage and the quality of such coverage, particularly among higher rate taxpayers and arrangements where there is a strong sense of personal ownership of the retirement funds, such as proprietary directors, the self employed and AVCs [additional voluntary contributions].
“In this regard, the option to take a tax free lump sum at retirement is very important to these groups as
they can arbitrage between the benefits of personal tax and PRSI /Health Levy relief on pension contributions and a tax free lump sum at retirement. The benefit of this arbitrage is magnified as the individual gets closer to retirement age.”
They suggest that tax policy could be geared towards encouraging retirement assets to be converted to a stream of income. For example, annuities could be given more favourable tax treatment than benefits paid out wholly in lump sum form.
The factors influencing people in their choice of the lump sum option are more complex, perhaps, than the simple addition or withdrawal of tax incentives. Monika Butler of the DEEP University of Lausanne and Federica Teppa of the CeRP University of Turin looked at the choice made by members of Swiss pension funds within the mandatory occupational pension system between an annuity and a lump
In general they found that people toed the company line and chose the annuity option. Their choice was dictated chiefly by the standard option offered by the pension fund or peer pressure - what they term an ‘an acquiescence bias’.
Preferential tax treatment does play a part, however, and in Switzerland, there is a clear a tax advantage in withdrawing accumulated pension wealth in the form of a lump sum.