PRUDENTIAL PLC

Prudential PLC

Prudential PLC

Introduction

An important issue in the design of pension systems is the extent to which workers have access to pension assets upon job change. The federal tax code discourages such cash settlements before retirement or disability in a number of ways. First, pensions enjoy the benefits of tax-deferral. Contributions are tax-deductible and accrue at the pre-tax interest rate. Contributions and interest are not taxed until withdrawal. However, all pre-retirement lump-sum distributions not rolled over into a tax-qualified plan, such as an Individual Retirement Account (IRA) or other pensions, are taxed as ordinary income in the year of receipt. Individuals who spend lump-sum distributions forego the benefits of tax deferral. This opportunity cost rises with the individual's marginal tax rate. Second, the Tax Reform Act of 1986 (TRA86) established a 10 percent excise tax on distributions to workers under 55 not rolled into a tax-qualified plan (Chang, 1996).

Despite these tax incentives to preserve pension assets until retirement, there is great concern by policy makers that workers will use lump-sum distributions to finance current consumption rather than retirement income. This will result in significant leakage of assets from the pension system. Concern is greatest for young workers, who have high job mobility, but may find retirement a distant prospect.

While there is a large literature that describes the determinants of the disposition of lump-sum distributions, little is known about the extent to which spent distributions erode retirement wealth. The current paper provides some evidence on this key policy issue. Specifically, it uses detailed retrospective information on employment histories, pensions, demographics, and wealth in the 1992 and 1998 waves of the Health and Retirement Study (HRS) to quantify the extent of retirement wealth erosion from pre-retirement lump-sum pension distributions. There is little evidence that spent distributions have resulted in significant pension leakage. If spent lump-sum distributions had been rolled over into a tax-qualified plan instead, they would have represented in present value between 5 and 11 percent of pension and Social Security wealth for the median household that spent a distribution. However, one-quarter of the households that spent distributions--which is 2.25 percent of all households age 51 to 61--could have increased their pension and Social Security wealth by 25 percent or more had the distributions been rolled over into a tax-qualified plan. This suggests that policies that enforce rollovers might not raise the retirement income security of the average American household currently entering retirement or that of the typical household that spent a distribution.

Distributions and Retirement Wealth Erosion

The primary policy concern is that lump-sum distributions consumed prior to retirement may erode retirement income security. While undoubtedly true, previous studies have provided no evidence that this is quantitatively important. This is primarily because data sources used in those studies, such as the CPS, lacked information on Social Security, pension, and other wealth needed to measure impact of the leakage of pension assets on household wealth.

With its detailed information on pensions, Social Security wealth, lifetime earnings, demographics, and non-pension wealth, the HRS offers a ...