Updated August 3, 2005

Patrick Purcell

Specialist in Social Legislation

Domestic Social Policy Division

Congressional Research Service ˜ The Library of Congress

Pension Issues: Lump-Sum Distributions and

Retirement Income Security

Summary

Slightly fewer than half of all workers age 21 and older participated in an

employer-sponsored retirement plan in 2003, but not all of these workers will receive

a pension or retirement annuity from the jobs they now hold. Many will receive a

“lump-sum distribution” from their retirement plan when they change jobs. A typical

25-year-old today will work for seven or more employers before reaching age 65, and

could receive several distributions before reaching retirement age.

Lump-sum distributions allow workers to re-invest their retirement assets so that

they will continue to grow until retirement. However, many recipients of lump-sum

distributions use all or part of the distribution for current consumption rather than

depositing the funds into an individual retirement account (IRA) or another

retirement plan. To encourage individuals to “roll over” these distributions into

another retirement plan, Congress in 1986 enacted a 10% excise tax on pre-

retirement pension distributions that are not rolled over. In 1992, Congress required

employers to withhold for income tax payment 20% of distributions that are paid to

recipients rather than rolled over into another retirement plan. In 2001, Congress

required that, unless directed otherwise by the participant, the plan sponsor must

deposit distributions of $1,000 or more into an individual retirement account.

According to data collected by the Census Bureau, 51.8 million workers age 21

or older participated in retirement plans that offered a lump-sum distribution as a

payment option in 2003. This represented 84.8% of the 61.1 million workers who

were covered by a pension, profit-sharing, or retirement savings plan in 2003.

Approximately 16.0 million people reported that they had received at least one lump-

sum distribution at some time in their lives. The average (mean) value of these

distributions was $21,900 and the median value was $6,000. The typical recipient

was between 37 and 40 years old at the time of the distribution. Thus, most

recipients of lump-sum distributions were more than 20 years away from retirement.

Of survey respondents who reported that they had received at least one lump-

sum distribution, 44% said that they had rolled over the entire amount of the most

recent distribution into an IRA or other retirement plan, accounting for 67.2% of the

dollars distributed as lump sums. Another 40% of recipients said that they had saved

at least part of the distribution in some other way. Of those who reported receiving

a distribution after 1992, 47% said that they had rolled over the entire amount into

another plan, accounting for 72% of the dollars distributed as lump-sums. Another

38% of this group said that they had saved at least part of the distribution.

Lump-sum distributions that are spent rather saved can reduce future retirement

income. If the lump-sum distributions received through 2002 that were not rolled

over had instead been rolled over into accounts that grew at the same historical rate

as the Standard & Poor’s 500 Index, they would have had a median value of $7,214

by 2003. For the typical recipient, if this amount were to remain invested, it would

grow to an estimated value of $31,100 by age 65, which would be sufficient to

purchase a level, single-life annuity that would pay $225 in monthly income.

Contents

Overview: Pension Coverage and Tax Policy........................1

Asset Preservation and Lump-Sum Distributions.................3

Calculating Lump-Sum Distribution Amounts...................5

Interest Rates and Lump-Sum Distributions.....................5

Lump-Sum Distributions and Pension Plan Funding...............6

How Many Workers Are Eligible for Lump-Sum Distributions?.........7

How Many People Have Received Lump-Sum Distributions?...........9

How Did Recipients Use Their Lump-Sum Distributions?..............9

How Much Retirement Wealth Was Lost from Lump-Sums that

Were Spent Rather than Saved?..............................14

What Would these Amounts have been Worth at Retirement?..........15

What Factors Influence the Rollover Decision?.....................15

Implications for Public Policy...................................20

List of Tables

Table 1. Participation in Employer-Sponsored

Retirement Plans, 2003.........................................2

Table 2. Percentage of Workers Whose Retirement Plan Offered a

Lump-Sum Payment Option, 2003................................8

Table 3. Characteristics of Individuals Who Reported Ever Having

Received One or More Lump-Sum Distributions....................9

Table 4. Percentage of Lump-Sum Distribution Recipients Who Rolled

Over the Entire Amount into Another Retirement Plan................12

Table 5. Percentage of Lump-Sum Distribution Recipients Who Saved

All or Part of the Distribution...................................13

Table 6. Disposition of Lump-Sum Distributions........................19

Overview: Pension Coverage and Tax Policy

Slightly fewer than half of all workers age 21 and older in the United States

participated in an employer-sponsored retirement plan in 2003.

of these workers, however, will receive a pension or retirement annuity from their

current jobs. Some workers will not participate in their employer’s retirement plan

long enough to earn the right to a pension — a process called “vesting.” Others will

receive a “lump-sum distribution” from the plan when they retire or when they

change jobs. A typical 25-year-old today will work for seven or more employers

before reaching age 65.

distributions from a retirement plan before reaching retirement age. What an

individual does with a lump-sum distribution — even a relatively small one — can

have a significant impact on his or her wealth and income during retirement. Lump-

sum distributions that are spent on current consumption rather than saved for

retirement will not be available to augment a worker’s retirement income.

Today, most retirees rely on Social Security for the majority of their income.

In 2003, more than two-thirds (68.3%) of Social Security beneficiaries age 65 or

older received more than half of their annual income from Social Security, and Social

Security was the only source of income for nearly one out of four (24%) beneficiaries

over the age of 65.

2003 was $925 per month, or $11,100 annually. Workers whose employer sponsors

a retirement plan have the opportunity to achieve higher standards of living and

greater financial independence in retirement than those who must rely on Social

Security alone. However, to the extent that workers spend lump-sum distributions

from employer-sponsored retirement plans rather than save them, they may be

undermining their future financial security.

Congress has provided incentives for workers to prepare for retirement by

granting favorable tax treatment to retirement plans that meet certain requirements

as to eligibility, benefits, and funding. Employers are permitted to deduct from

A “retirement plan” may be either a traditional defined benefit pension plan or a retirement

savings plan, such as those authorized under Internal Revenue Code §401(k).

Bureau of Labor Statistics, “Employee Tenure in 2004,” BLS News Release, USDL 04-

1829, Sept. 21, 2004.

income amounts they contribute to employee retirement plans. These employer

contributions are not taxed as income to participating employees until they begin

receiving distributions from the plan.

Table 1. Participation in Employer-Sponsored

Retirement Plans, 2003

(all wage and salary workers age 21 and older)

Participate in aYesNo Total Persons

Retirement Plan?(in percent) (in percent) (in thousands)

Total 0.5 0.0 131,253

Employers who sponsor retirement plans do so voluntarily. However, an

employer who chooses to sponsor a retirement plan must comply with both the

Employee Retirement Income Security Act of 1974 (P.L. 93-406), popularly known

as “ERISA,” and the Internal Revenue Code. A plan that fails to meet the standards

set forth in federal law may be denied the status of a “tax-qualified” plan.

The tax revenue forgone by the federal government as a result of the deductions

and exclusions granted to qualified retirement plans is substantial. According to the

congressional Joint Committee on Taxation, the net exclusion for employer pension

plan contributions and earnings will result in $568 billion in forgone tax revenue over

the five fiscal years from 2005 through 2009.

expenditure in the federal budget.

Asset Preservation and Lump-Sum Distributions. Pension plans and

retirement savings plans, such as “401(k)” plans, promote financial security in

retirement by encouraging workers to accumulate assets to pre-fund their retirement

income. Sometimes, however, retirement assets are distributed before the worker

has reached retirement age. This can happen in the event that a plan is terminated or,

more commonly, when a worker moves from one job to another. In such cases, the

present value of the benefit that the employee has earned to date — his or her

“accrued benefit” — is typically paid out in a single lump-sum distribution from the

plan. In the case of a 401(k)-type plan, the distribution is equal to the balance in the

employee’s account: employee contributions, investment earnings (or losses) on

those contributions, and the part of employer contributions and earnings in which the

employee has become vested. In defined benefit pension plans, a lump-sum

distribution is required by law to be equal to the present value of the employee’s

accrued benefit. The present value calculation discounts the stream of benefits that

are the exclusion of employer payments for health insurance, which is estimated to reduce

federal tax revenue by $494 billion from 2005 to 2009, the home mortgage interest

deduction ($434 billion), the reduced tax rates on dividends and long-term capital gains

($357 billion), and the tax credit for children under age 17 ($232 billion).

taxable income amounts contributed to, and earnings on, these plans. 401(k) plans are

authorized for private, for-profit employers. Similar arrangements for non-profit employers

are authorized by §403(b) and for employees of state and local governments under §457.

“cliff” vesting and “graded” vesting. The maximum permissible vesting period differs

between defined benefit plans and defined contribution plans. Under cliff vesting in a

defined benefit plan, a participant is 100% vested after five years of participation, but has

no vested rights to a benefit under the plan before that time. Under “graded” vesting in a

defined benefit plan, a participant is 20% vested after three years, 40% vested after four

years, 60% vested after five years, 80% vested after six years, and 100% vested after seven

years. In a defined contribution plan, the vesting schedule applicable to an employer’s

matching contributions may not exceed three years under year cliff vesting or six years

under graded vesting. Employers can, if they choose, vest participants in their accrued

benefits faster than these schedules.

would be paid in the future to an amount that could, if invested by the recipient, pay

an equivalent income at retirement.

Lump-sum distributions promote “portability” of retirement assets for workers

who change jobs, allowing them to re-invest their retirement assets so that they will

continue to grow until retirement. A transfer of assets from one tax-qualified

retirement plan to another is referred to as a “rollover” of assets into another plan.

Pension analysts describe pre-retirement distributions that are spent on current

consumption rather than being rolled over into another retirement plan as “leakages”

from the pool of retirement assets. To discourage leakages from retirement plans,

Congress has amended the Internal Revenue Code to provide incentives for

individuals to roll over pre-retirement distributions into other retirement plans.

tax — in addition to ordinary income taxes — on lump-sum

distributions received before age 59½ that are not rolled over into an

Individual Retirement Account (IRA) or another employer’s tax-

qualified retirement plan.

318) required employers to give departing employees the option to

transfer a lump-sum distribution directly to an IRA or to another

employer’s plan. If the participant instead chooses to receive the

distribution directly, the employer is required to withhold 20%,

which is applied to any taxes due on the distribution. If the

participant does not deposit the distribution into an IRA or another

tax-qualified plan within 60 days, he or she will owe both regular

income taxes and the 10% excise tax on the entire amount of the

distribution.

employee his or her accrued benefit under a retirement plan without

the participant’s consent if the present value of the benefit is less

than $5,000.

of money, based on a specific rate of interest, and also for mortality among plan participants.

“substantially equal periodic payments” based on the recipient’s life expectancy or if the

recipient has retired from the plan sponsor at age 55 or older. See CRS Report RL31770,

Retirement Savings Accounts: Early Withdrawals and Required Distributions, by Patrick

J. Purcell.

taxes owed on the distribution. If the distribution is rolled over within the 60-day limit, the

20% withheld is credited toward the individual’s total income tax owed for the year. Note

that to roll over the full amount after receiving a lump-sum distribution, the recipient must

have access to other funds that are at least equal to the amount withheld.

limit was established by the Taxpayer Relief Act of 1997 (P.L. 105-34). The amount had

been set at $3,500 by Retirement Equity Act of 1984. It was originally established at $1,750

(continued...)

Act of 2001 (P.L. 107-16) required that, if a plan makes such a

distribution and the present value of the benefit is at least $1,000, the

plan must deposit the distribution into an individual retirement

account unless otherwise instructed by the participant.

Obviously, there may be times when the recipient of a lump-sum distribution

faces expenses that are more pressing than concerns about retirement. This is

especially so when the recipient is in a period of unemployment or must pay for the

care of a relative who is ill or disabled. Previous research has shown that the event

precipitating a lump-sum distribution (losing one’s job, for example), is a key

determinant of whether the distribution is rolled over into another retirement plan,

saved in some other way, or spent on current consumption. Surveys of employers

and employees indicate that the availability of lump-sum distributions has a positive

effect on employee participation in retirement plans. Consequently, Congress has

sought to encourage recipients to roll over pre-retirement distributions, rather than

requiring that such distributions be rolled over into an IRA or another retirement

plan. Allowing lump-sum distributions while placing an excise tax on amounts that

are not rolled over represents a compromise among the competing policy objectives

of promoting retirement saving, preserving assets until retirement, providing access

to assets in time of need, and assuring that lost tax revenue does not exceed the

amount necessary to encourage employer sponsorship and employee participation.

Calculating Lump-Sum Distribution Amounts. When a lump-sum

distribution is paid from a defined contribution plan, such as a 401(k) plan, the

amount distributed is simply the account balance. In paying a lump-sum distribution

from a defined benefit plan, however, the plan sponsor must calculate the present

value of the benefit that would be payable to the plan participant when he or she

reaches the plan’s normal retirement age. When calculating this amount, the plan is

required by law to use the interest rate that is specified in the Internal Revenue Code.

I.R.C. §417(e) specifies the interest rate on 30-year U.S. Treasury Bonds as the

discount rate to be used by plan sponsors when calculating the present value of a plan

participant’s accrued benefit. The U.S. Treasury stopped issuing 30-year bonds in

2001. Congress is now considering alternative interest rates that could be used to

calculate the present value of accrued benefits under defined benefit plans. H.R.

2803 (Boehner) of the 109 Congress would replace the interest rate on 30-year

Treasury Bonds as the rate for calculating lump-sum distributions with an interest

rate based on an average of the interest rates on high-quality, long-term and short-

term corporate bonds. The corporate bond rate would be phased in over five years

beginning in 2006.

Interest Rates and Lump-Sum Distributions. The amount of a lump-

sum distribution from a defined benefit pension is inversely related to the interest

used to calculate the present value of the benefit that has been accrued under the plan:

the higher the interest rate, the smaller the lump-sum and vice versa. Under current

law, lump-sum distributions are calculated using the average interest rate on 30-year

Treasury bonds. The interest rate on long-term Treasury securities has historically

by ERISA in 1974.

been lower than the average interest rate on long-term investment-grade corporate

bonds because bond markets generally consider U.S. Treasury securities to be free

of the risk of default. Since the Treasury Department stopped issuing the 30-year

bond in 2001, the interest rate on 30-year Treasury bonds that have not yet been

redeemed has fallen as the supply of bonds has shrunk. (Bond prices and interest

rates are inversely related. As bond prices rise, bond yields — interest rates — fall.)

H.R. 2830 would require plan sponsors to calculate lump-sum distributions

using three interest rates based on investment-grade corporate bonds. As a result,

participants of different ages would have their lump sum distributions calculated

using different interest rates. Lump-sum distributions paid to workers nearer to

retirement would be calculated using a short-term interest rate, and distributions paid

to younger workers would be based on a long-term rate. Because short-term rates

are usually lower than long-term rates, all else being equal, an older worker would

receive a larger lump-sum than a similarly situated younger worker.

Assuming that a participant were to take a lump-sum distribution at the plan’s

normal retirement age (typically age 65), a short-term corporate interest rate would

be applied to the annuity payments he or she would have received during the first five

years of retirement. A medium-term interest rate would apply to payments the

participant would have received in years six through 20, and a long-term rate would

apply to payments that would have been paid after 20 years. Because a 65-year-old

can be expected to live about another 20 years, most of the lump-sum would be based

on the medium-term rate. In contrast, a participant who takes a lump-sum

distribution at age 45 would be 20 years away from the plan’s normal retirement age.

All of that person’s lump sum will be discounted at the higher long-term rate. If a

person took a lump sum at, say, age 59, the distribution would be calculated using the

both the medium-term and long-term rates, but not the short-term rate.

Lump-Sum Distributions and Pension Plan Funding. Further increases

in the proportion of plan participants taking lump-sum distributions from defined

benefit pension plans could have important implications for pension plan funding.

The Executive Director of the Pension Benefit Guaranty Corporation (PBGC) has

stated that “plan assets are depleted when seriously underfunded plans allow retiring

employees to elect lump sums and similar accelerated benefits.” Likewise, the U.S.

Government Accountability Office (GAO) has reported to Congress that:

. . . because many plans allow lump sum distributions, plan participants in an

underfunded plan may have incentives to request such distributions. For

example, where participants believe that the PBGC guarantee may not cover their

full benefits, many eligible participants may elect to retire and take all or part of

their benefits in a lump sum rather than as lifetime annuity payments, in order to

maximize the value of their accrued benefits. In some cases, this may create a

“run on the bank,” exacerbating the possibility of the plan’s insolvency as assets

are liquidated more quickly than expected, potentially leaving fewer assets to pay

benefits for other participants.

How Many Workers Are Eligible for Lump-Sum Distributions?

During the first half of 2003, the Census Bureau asked participants in the Survey

of Income and Program Participation (SIPP) a series of questions on retirement

expectations and pension plan coverage. According to this survey, 85% of the 61.1

millions workers age 21 or older who were included in a retirement plan at work

participated in a plan that offered a lump-sum distribution as a payment option.

(See Table 2.)

Almost all defined contribution plans offer a lump-sum payment option. The

proportion of defined benefit plans offering lump-sum distributions has risen in

recent years as many employers have converted traditional defined benefit pension

plans to “cash balance plans.” These are hybrid pensions that have some of the

characteristics of defined contribution plans, most significantly in that a participant’s

accrued benefit is reported as an “account balance.” Nevertheless, cash balance plans

are funded on a group basis and are treated as defined benefit plans under the Internal

Revenue Code. Cash balance plans typically offer lump-sum distributions to

departing employees.

Structural Problems Limit Agency’s Ability to Protect Itself from Risk,” GAO-05-360T.

defined benefit plans who reported that the plan offered a lump-sum distribution option.

Table 2. Percentage of Workers Whose Retirement Plan Offered

a Lump-Sum Payment Option, 2003

(workers 21 and older who participated in an employer-sponsored

retirement plan)

Does Plan Have aYesNo Persons

Lump-sum Option?(percent) (percent) (thousands)

Total 84.8 15.2 61,082

How Many People Have Received Lump-Sum Distributions?

According to the information reported on the Survey of Income and Program

Participation in 2003, an estimated 16.0 million individuals age 21 or older had

received at least one lump-sum distribution from a retirement plan at some point

during their lives. The average (mean) value of these distributions in nominal dollars

was $21,895. Expressed in constant 2003 dollars, the mean value of the distributions

was $25,968.

skewed upward by a relatively small number of large distributions, the “typical”

distribution is more accurately portrayed by the median, which in nominal dollars

was $6,000. Adjusted to 2003 dollars, the median distribution was $7,581. The

average recipient was between the ages of 37 and 40 at the time of the most recently

received lump-sum distribution. Thus, most people who received these distributions

were more than 20 years away from retirement age.

Table 3. Characteristics of Individuals Who Reported Ever

Having Received One or More Lump-Sum Distributions

Recipient Age and Amount of Distribution:Mean Median

All recipients of lump-sum distributions:

Age when lump sum received 4037

Amount of lump-sum distribution in nominal dollars$21,895$6,000

Amount of lump-sum distribution in 2003 dollars$25,968$7,581

Rolled over the distribution to another account :

Age when lump sum received 4240

Amount of lump-sum distribution in nominal dollars$33,810$12,000

Amount of lump-sum distribution in 2003 dollars$39,400$13,332

Did not roll over the distribution to another account:

Age when lump sum received 3835

Amount of lump-sum distribution in nominal dollars$12,420$4,000

Amount of lump-sum distribution in 2003 dollars$15,288$4,464

How Did Recipients Use Their Lump-Sum Distributions?

Research into lump-sum distributions has consistently found that the majority

of distributions are not rolled over into other qualified retirement savings plans, but

that the majority of dollars are rolled over. In other words, small distributions are

less likely to be rolled over, but large distributions — which account for most of the

money distributed — are more likely to be rolled over. Researchers also have found

constant 2003 dollars, based on the Personal Consumption Expenditure Index of the

National Income and Product Accounts (NIPA).

however, that most recipients of lump-sums saved at least part of the distribution,

even if none of the money was rolled into another retirement plan.

Of those who reported to the Census Bureau that they had received at least one

lump-sum distribution, 44% said that they had rolled over the entire amount of the

most recent distribution into another tax-qualified plan, such as an IRA. (See Table

4.) These transactions accounted for 67% of the dollars distributed as lump sums.

(Not shown in table.) Of those who reported receiving a distribution after 1992, 47%

said that they had rolled over the entire amount into another plan, accounting for 72%

of the dollars distributed as lump-sums after 1992.

Rolling over a lump-sum distribution into another tax-qualified retirement plan

is the most efficient way to preserve these assets for retirement, because direct

rollovers are not subject to taxes, tax penalties, or employer withholding.

Nevertheless, it is not the only way to save a lump-sum distribution. Survey

participants who reported that they had not rolled over the entire amount of a lump-

sum distribution were asked what they did with the money. Eighteen options were

listed, and respondents could indicate more than one if they used the money for more

than one purpose. (Survey participants were asked only how they used the money,

not how much was used for each purpose). Nine of the categories listed fit the

standard economic definition of “saving” in that they lead to (or are expected to lead

to) an increase in a household’s net worth.

improvements,

Among those who reported that they had received at least one lump-sum

distribution, 84% said that they had saved at least some of the most recent

distribution they received. (See Table 5.) In addition to the 44% who had rolled

over the entire amount into another tax-deferred retirement plan, another 40% saved

at least part of the distribution in one of the other ways listed above. Of those who

had received their most recent lump-sum distribution after 1992, 85% said that they

had saved at least part of the distribution. Of this group, 47% rolled over the entire

amount into another plan, and 38% saved part of the distribution in another way.

consumer items; used for vacation, travel, or recreation; paid expenses while laid off; used

for moving or relocation expenses; used for medical or dental expenses; paid or saved for

education; used for general or everyday expenses; gave to family members or charity; paid

taxes; and spent in other ways.

Trend From 1998 to 2003. Prior to 2003, the Census Bureau last collected

information on the disposition of lump-sum distributions from pension plans in 1998.

In the 1998 survey, 35.9% of respondents reported that they had rolled over the entire

amount of the most recent lump-sum distribution they had received into an IRA or

another employer-sponsored retirement plan. The data displayed in Table 4 show

that 44.3% of the respondents to the 2003 survey reported having rolled over their

most recently received lump-sum distribution. While these figures may appear to

represent a substantial increase in the percentage of recipients who chose to roll over

their lump-sum distributions between 1998 and 2003, they primarily reflect changes

in participant behavior that had already occurred by 1998.

In the1998 Census Bureau survey, 35.9% of respondents reported that they had

rolled over their most recent lump-sum distribution into another retirement plan. Of

7.0 million people whose most recent lump-sum distribution occurred before 1993,

only 29.2% reported that they had rolled over the entire amount into an IRA or

another retirement plan. Of 7.3 million people whose most recent lump-sum

distribution occurred between 1993 and 1998, 42.4% reported that they had rolled

over the entire amount into another plan.

In the 2003 Census Bureau survey, 44.3% of respondents reported that they had

rolled over their most recently received lump-sum distribution into another retirement

plan. Of 4.7 million people whose most recent lump-sum distribution occurred

before 1993, 38% had rolled over the entire amount into an IRA or another retirement

plan. Of another 4.7 million people whose most recent lump-sum distribution was

received between 1993 and 1998, 49.2% reported that they had rolled over the entire

amount into another plan. Finally, of 6.7 million people whose most recent lump-

sum distribution was received after 1998, 45.2% reported that they had rolled over

the entire amount into another plan.

The increase from 35.9% of lump-sum recipients reporting a rollover in the

1998 survey to 44.3% of recipients who reported a rollover in the 2003 survey largely

reflects changes in behavior that had already occurred by 1998. In the 2001 survey,

the percentage of individuals who reported rolling over their most recent lump-sum

distribution was actually lower for distributions received after 1998 or later than it

was for distributions received between 1993 and 1998. When comparing the

disposition of recently received lump-sum distributions in the two surveys, the

percentage of distributions that were rolled over into another plan was only slightly

higher in the 2003 survey than in the 1998 survey. In 1998, 42.4% of respondents

who had received a lump-sum distribution within the last five years reported that they

had rolled over the full amount of the distribution into another retirement plan. In the

2003 survey, the comparable figure was 45.8%, an increase of just 3.4 percentage

points. Thus, the higher overall percentage of recipients who reported having rolled

over their most recent lump-sum distribution in the 2003 survey — 44.3%, as

compared to 35.9% in the 1998 survey — results mainly from the fact that a much

larger proportion of the distributions represented in the 2003 survey occurred after

1992.

Table 4. Percentage of Lump-Sum Distribution Recipients Who

Rolled Over the Entire Amount into Another Retirement Plan

Table 5. Percentage of Lump-Sum Distribution Recipients Who

Saved All or Part of the Distribution

Was any part of theYesNoPersons

distribution saved?(percent)(percent)(thousands)

Age when received

Race

Sex

Marital status

Children present

Education

Home ownership

Income in 2003

Amount of distribution

Year distribution received

Total 84.1 15.9 16,007

How Much Retirement Wealth Was Lost from Lump-Sums

that Were Spent Rather than Saved?

Older workers are more likely than their younger colleagues to roll over a lump-

sum distribution of any given size into an IRA or other retirement plan. For example,

according to the SIPP, among workers who received a distribution between the ages

of 25 and 34, only 39.2% rolled over the entire amount into an IRA or other

retirement plan. Of those who received a distribution between the ages of 45 and 54,

51.6% rolled over the entire amount. (See Table 4.) Younger workers, however, are

more likely to receive relatively small lump-sum distributions because they generally

have fewer years of service and have lower annual earnings than older workers.

Among participants in the SIPP who had received at least one lump-sum

distribution, the average (mean) value of the most recent distribution was $21,895.

Average values differed sharply for amounts that were rolled over versus those that

were not. Among recipients who had rolled over the entire amount, the average

distribution was $33,810. Those who had not rolled over the entire distribution

received lump-sums with a mean value of $12,420. (See Table 3.)

Although younger workers often receive relatively small lump-sum

distributions, substantial amounts of retirement wealth can be lost by spending rather

than saving even a small sum, especially in the case of workers who are many years

from retirement. To gauge the size of the potential loss in retirement wealth among

people who reported that they had not rolled over their most recent lump-sum

distribution, the Congressional Research Service (CRS) calculated the amounts that

these individuals could have accumulated if they had rolled over their entire lump

sums into another retirement plan. For each individual who had not rolled over the

most recent lump-sum distribution, CRS calculated the amount that would have been

accumulated by 2003 if the entire lump-sum had been rolled over in the year it was

received. The estimates were based on two possible rates of return:

year since the year the distribution was received; and

index in each year since the distribution was received.

If all of the respondents who reported that they had not rolled over their most

recent lump-sum distribution would have instead rolled over the full amount into a

fund that earned an interest rate equal to that paid by 10-year U.S. Treasury notes, the

distributions would have attained a mean value of $37,427 by 2003. If the lump-

sums had been rolled over into investments that grew at a rate equal to the total

annual return of S&P 500 index, the distributions would have had a mean value of

$41,272 by 2003.

As noted earlier, the mean value of lump-sum distributions is skewed upward

by the effects of a relatively small number of very large distributions. Consequently,

the “typical” distribution is more accurately portrayed by the median. If all of the

distributions that had not been rolled over into another retirement plan had instead

been rolled into a retirement account that was invested in stocks that matched the

total annual rate of return achieved by the S&P 500 index, the lump sums would have

had a median value of $7,214 by 2003. If invested in bonds that earned the rate of

return paid by 10-year U.S. Treasury notes, the median lump sum would have been

worth $6,930 by 2003.

What Would these Amounts have been Worth at Retirement?

If we consider age 65 to be retirement age, the typical individual who had

received a distribution but did not roll it over into another retirement account was

from 27 to 30 years away from retirement in the year that he or she received the

distribution. Their mean age in the year that they received their distributions was 38.

Their median age in the year of the distribution was 35. In 2003 — the year of the

survey — the median age of these individuals was 46.

As noted above, the median value of the lump-sum distributions that were not

rolled over would have reached $7,214 by 2003 if they had been invested in a broad-

based stock market index fund. Assuming a future average annual rate of return in

the stock market of 8%, a 46 year-old individual who invested $7,214 for 19 years

would have accumulated $31,130 by age 65. At current interest rates, this would be

enough to purchase a life-long annuity that would provide income of $225 per

month.

If the lump sums that were not rolled over had been rolled into an account

paying the same rate of return as 10-year Treasury notes, they would have reached

a median value of $6,930 in 2003. Assuming 46 year-old individual invested $6,930

in bonds for 19 years at an average rate of return of 5.8%, it would grow to $20,230

by age 65.

would provide a monthly income of $147.

What Factors Influence the Rollover Decision?

Older recipients and those who receive larger-than-average lump sums are

relatively more likely to roll over their distributions into an IRA or other tax-qualified

retirement plan. In other words, both the recipient’s age and the amount of the

distribution are positively correlated with the probability that a lump-sum

distribution will be rolled over into another retirement plan. Simple descriptive

statistics such as these, however, can be misleading because they show the

relationship between only two variables; for example, between age and the likelihood

of a rollover, or between the amount of the distribution and the likelihood of a

rollover. In fact, there are many variables that simultaneously affect the rollover

decision, and some of them have strong interaction effects on each other. In other

words, the decision to roll over a lump-sum or to spend it is affected not just by the

recipient’s age, and not just by the size of the distribution, but by both of these

Trustees of the Social Security System was 5.8%.

factors, and many others. This decision, like all economic choices, is made in the

context of numerous considerations.

To study the relationship between the rollover decision and a set of variables

suggested by both economic theory and previous research, CRS developed a

regression model in which the dependent, or response, variable could have two

possible values: 1 (true) if the entire lump-sum distribution was rolled over into

another retirement plan, and 2 (false) if any of the distribution was used for any other

purpose. The independent variables we tested were the individual’s age in the year

the distribution was received, race, sex, marital status, level of education, presence

of one or more children in the family, home ownership, monthly income, the amount

of the lump-sum distribution, and the year the distribution was received. In the

model, we restricted the sample to lump-sums received after 1986 by people under

age 60 in the year of the distribution. Results of the model are shown in Table 6.

Interpreting the Regression Results

We used a logistic regression or “logit” for our analysis. This is a form of multivariate

regression that was developed to study relationships in which the dependent (response)

variable can have only a limited number of values, such as yes (true) or no (false). In this

model, the dependent variable indicates whether a lump-sum distribution was rolled over

into another retirement account (1 = yes; 2 = no). The model measures the likelihood of

observing the dependent variable having a value of 1 (“yes”) when a particular independent

variable is changed, given that every other independent variable is held constant at its mean

value. The model estimates a coefficient (also called a parameter estimate) for each

independent variable and calculates the standard error of the estimate. The standard error

measures how widely the coefficients are likely to vary from one observation to another.

In general, the greater the absolute value of the parameter estimate, the more likely it is to

be statistically significant. Statistical significance is expressed in confidence intervals that

are measured as the .10 level, .05 level and .01 level. If a variable is significant at the .05

confidence level, for example, there is only a one-in-twenty chance that it is not related to

the dependent variable in the way that the model has predicted.

The model also generates for each independent variable a statistic called the odds

ratio. The odds ratio is a measure of how much more (or less) likely it is for a specific

outcome to be observed when a particular independent variable is “true” (x=1) than it is

when that independent variable is “false” (x=0). For example, in this model, home

ownership is measured as having a value of 1 if the recipient of a lump-sum distribution was

a homeowner and 0 otherwise. In Table 6, this variable is shown as having an odds ratio

of 1.69. This means that the dependent variable is 69% more likely to have a value of 1

(rollover = yes) when the dependent variable own home has a value of 1 (yes) as when it has

a value of 0 (no). In other words, other things being equal (and measured at their mean

values), a recipient of a lump-sum distribution who owned or was buying a home was about

69% more likely than a renter to have rolled over the entire lump sum into another

retirement plan.

before age 59½ that are not rolled over into another retirement plan. The Unemployment

Compensation Amendments of 1992 required employers to offer a direct rollover option to

departing employees and to withhold for income taxes 20% of distributions paid directly to

recipients. Results were similar in a second model that included all recipients of lump-sums,

regardless of age in the year of distribution or the year the distribution was received.

Our analysis of data from the SIPP found that the variable with the strongest

relationship to the likelihood that a lump-sum distribution was rolled over was the

amount of the distribution. In the regression model, lump-sum distributions were

divided into four size categories: less than $3,500; $3,500 to $9,999; $10,000 to

$19,999; and $20,000 or more.

Relative to distributions of less than $3,500, the probability that a distribution was

rolled over was positive and statistically significant for all larger distribution

amounts. Lump sums of $3,500 to $9,999 were 63% more likely to be rolled over

than lump sums of less than this amount. Lump-sum distributions of $10,000 to

$19,999 were 102% more likely to be rolled over than lump sums of less than $3,500.

Distributions of $20,000 or more were 329% more likely to be rolled over than were

distributions of less than $3,500.

The variable indicating the year the distribution was received had a positive and

statistically significant relationship to the probability that a lump-sum distribution

was rolled over into another retirement plan. Other things being equal, lump sums

received in 1993 or later were 38% more likely to have been rolled over than those

received between 1987 and 1992.

Race was also a significant variable on the model. White recipients of lump-

sum distributions were 96% more likely than non-white recipients to have rolled over

their distribution into an IRA or other retirement plan. On the one hand, this result

may be seen as troubling because the regression model controls for the effects of

other variables — such as income and education — that correlate with race. On the

other hand, given that access to financial information and advice is partly dependent

on one’s occupation and industry of employment, it may be possible to influence

savings behavior through public policies, such as subsidizing the distribution of

information to workers about the long-term consequences of spending rather than

saving a pre-retirement pension distribution.

Home ownership and being married were positively and significantly related to

the probability that a lump-sum distribution was rolled over. Homeowners were

about 69% more likely to have rolled over their most recent lump-sum distribution.

Purchasing a home is itself a form of investment, and — controlling for the effects

of income — homeowners have what economists call a “revealed preference” for

saving and investment compared to renters. Other things being equal, married

individuals were 35% more likely than unmarried persons to have rolled over lump-

sum distribution into a retirement plan. The presence of children in the family,

however, had a negative relationship to the probability of rolling over a distribution.

People with children under age 18 were 30% less likely to have rolled over a

distribution compared to people with no children. The likely reason for the negative

impact on rollovers of children in the family is that people with children face

numerous expenses that childless individuals do not. These additional financial

responsibilities could make the preservation of a lump-sum distribution a lower

priority than it otherwise would be.

distributions in this analysis occurred in years when $3,500 was the largest amount that an

employer could pay to a departing employee without securing written consent.

Age in the year of the distribution, education, and average monthly income were

included in the model in broadly defined categories. Recipients were grouped into

four age categories according to when they received their most recent distribution:

under 35; 35 to 44; 45 to 54; and 55 or older. Relative to recipients under age 35,

workers aged 35 to 44 and those aged 45 to 54 were 28% and 29% more likely,

respectively than the youngest group to have rolled over their most recently received

lump sum. Recipients aged 55 and older were 48% more likely than those under 35

to have rolled over their most recently received lump sum distribution.

Recipients were classified into three groups designating their highest year of

education: up to 12 years of school; 1 to 3 years of college; and 4 or more years of

college. Having completed college bore a significant and positive relationship to the

probability that a lump sum was rolled over. Relative to those with a high school

education or less, recipients with 1 to 3 years of college were 27% more likely to

have rolled over their distribution into an IRA or other retirement plan. College

graduates, however, were 206% more likely than those with just a high school

education to have rolled over their most recent lump-sum distribution. This result

could be considered encouraging to the prospect that savings behavior can be

influenced by efforts to educate workers about the importance of saving pension

distributions for their needs during retirement.

The SIPP collected information about respondents’ current earnings, but not

their earnings in the year they received their most recent lump-sum distribution.

Current earnings were entered into the regression model as a proxy for income in the

year the distribution was received. The respondents’ average monthly income in

2003 was grouped into three categories: under $2,000; $2,000 to $3,999; and more

than $4,000. On an annualized basis, these groupings correspond to yearly earnings

of under $24,000, $24,000 to $48,000, and more than $48,000, respectively. Relative

to recipients with monthly earnings of less than $2,000, those who had earnings from

$2,000 to $3,999 were neither more nor less likely to have rolled over their most

recent lump-sum distribution into an IRA or other retirement account. (The sign for

this variable was positive, but the coefficient was not statistically significant).

Having monthly income of more than $4,000 was significantly and positively related

to the likelihood that a distribution was rolled over. Individuals with monthly income

of more than $4,000 were 101% more likely to have rolled over their most recent

lump sum.

The variable indicating the recipient’s sex was statistically significant, but just

barely (at the .10 level). Other things being equal, men were 15% less likely than

women to have rolled over their most recent lump-sum distribution into another

retirement plan.

Table 6. Disposition of Lump-Sum Distributions

(lump-sums received after 1986 by persons under age 60)

Logistic Regression Results

Response Variable: Full distribution was rolled over into an IRA or other

retirement account

Analysis WeightedParameterStandardOdds

VariableMeanEstimateError Ratio

Intercept — -2.9360.221—

Race (1 = white)0.8930.6750.1441.964

Sex (1 = male)0.474-0.1620.0890.85

Marital status (1 = married)0.6560.2990.1011.348

Children in family (1 = yes)0.434-0.3640.1000.695

Own home (1 = yes)0.7810.5250.1111.690

Age = 35 to 440.2910.2440.1021.277

Age = 45 to 540.2030.2560.1241.294

Age = 55 or older0.0730.3900.1801.478

Education: some college0.3380.2360.1121.266

Education: 4+ years college0.4151.1190.1133.063

Monthly income: $2,000-0.3460.1640.1001.178

Monthly income: $4,000+0.2700.6980.1162.010

Lump sum: $3,500 - $9,9990.2400.4880.1091.628

Lump sum: $10,000-$19,9990.1410.7040.1292.022

Lump sum: $20,000 or more0.2511.4570.1184.293

Received after 1992 (1= yes)0.8220.3220.1101.380

Association of Predicted Probabilities and Observed Responses

Concordant = 75.9%, Discordant = 23.8%, Tied = 0.3%

Implications for Public Policy

The results of this analysis indicate that while fewer than half of lump-sum

distributions from retirement plans have been rolled over into IRAs or another

employer-sponsored plan, about two-thirds of the dollars distributed as lump sums

have been rolled over. Increases in the proportion of distributions that are rolled over

followed both the imposition of an excise tax on non-rollovers by the Tax Reform

Act of 1986 and the tax withholding and institutional rollover mechanisms mandated

by the Unemployment Compensation Amendments of 1992. However, the

percentage of recently received lump-sum distributions that were rolled over into

another plan was only slightly higher in the Census Bureau’s 2003 survey than it had

been in the 1998 survey. In 1998, 42.4% of respondents who had received a lump-

sum distribution within the last five years reported that they had rolled over the full

amount of the distribution into another retirement plan. In 2003, the comparable

figure was 45.8%, an increase of just 3.4 percentage points in the percentage of

recent distributions that were rolled over into another retirement plan.

Many recipients of lump-sums who did not roll over their distributions into an

IRA or other retirement plan saved at least some of the money in another way. While

44% of recipients rolled over the entire amount, another 40% used at least part of

their lump-sum to purchase a home or business, invest in stocks or bonds, or to make

a deposit to a savings account. Thus, 84% of all recipients saved at least part of their

lump-sum distribution. However, taking a distribution and saving part of it is not a

tax-efficient way to save. Distributions received before age 59½ that are not directly

rolled over into another tax-qualified retirement plan are subject to both ordinary

income tax and a 10% additional tax.

While the lump-sum distributions that were not rolled over tended to be

relatively small — with a median value of $4,000, compared to a median value of

$12,000 for lump-sums that were rolled over — most were received by workers who

were more than 20 years away from retirement. Consequently, many of these

distributions could have grown to substantial amounts had they been rolled over into

IRAs or other retirement plans. Among the sample of lump-sum recipients examined

in this report, those who did not roll over their most recent lump sum distribution

gave up retirement wealth with an estimated median value of $31,000 at age 65 if it

had been invested in stocks, or $20,000 if it had been invested in bonds.

The tax policies that Congress has adopted toward early distributions from

retirement plans represent a compromise among several competing objectives,

including:

plans,

they would otherwise face substantial economic hardship, and

plans are not used for purposes other than to fund workers’ future

financial security.

If any one of these objectives were paramount, devising the most effective

policy would be a relatively straightforward undertaking. If preserving retirement

assets were the only important consideration, Congress could require all distributions

from pension plans to be rolled over into another account and held there until the

individual reaches retirement age. Stricter limits on access to retirement funds before

retirement, however, could inhibit employee participation in retirement savings

plans. This, in turn, could result in more people being unprepared for retirement than

currently results from some pre-retirement distributions being spent rather than

saved. Likewise, allowing easier access to retirement savings could help people meet

other important expenses, but only at the expense of less financial security in

retirement.

Given the competing demands that Congress faces in devising tax policy for

pre-retirement distributions from pensions and retirement savings plans, the most

likely outcome is that these policies will continue to represent a compromise among

competing objectives. Policy analysts who have studied the effects of federal tax

laws on the disposition of lump-sum distributions have suggested several options for

consideration, including: changing the tax rate or the withholding rate on lump-sum

distributions that are not rolled over; having the tax rate vary with the age of the

recipient or with the size of the distribution; requiring at least part of the distribution

to be rolled over directly into another retirement plan; and encouraging plan sponsors

to educate recipients about the importance of preserving these distributions so that

the funds will be available to provide for their financial security during retirement