Effects of Public Policies on the Disposition of Pre-Retirement Lump-Sum Distributions: Rational and Behavioral Influences

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Pre–retirement lump sum distributions (LSDs) are sizable and have grown rapidly in recent years. Moreover, a variety of trends, including the shift toward defined contribution plans, suggest that distributions will become even larger in the future. The central goal of this project is to provide a theoretical and empirical examination of the determinants of households’ choices regarding the disposition of lump sum distributions. The results should help inform policy debates regarding pensions, retirement income security, and Social Security reform.

Previous analyses of LS behavior reach an uncommonly uniform set of conclusions: Most people who receive LSDs do not roll over the funds into qualified accounts, but a much larger portion of dollars received are rolled over. The likelihood that a worker will roll over the LSD rises with age, income, the size of the distribution, education and interest income. The loss in retirement income due to cashed–out LSDs is relatively small.

The project aims to extend existing knowledge of LSDs in four ways. First, we develop a new theoretical model of LSD choices and show that it is consistent with the stylized facts noted above. Second, we carefully model the tax rates applied to LSDs, which depend on the year the LSD was received, the age of the recipient, the size of the distribution and other factors, and which has changed dramatically over time, particularly in the 1986 Tax Reform Act.

Third, we estimate the impact of tax policy on rollover choices as well as broader measures of saving out of the distribution. Fourth, we test the hypothesis that, although overall retirement income loss appears to be small, the impact on the retirement income of the affected groups and on the adequacy of saving may still be relatively large. The estimates may overstate the effect because of non-rollover uses of LSDs that nevertheless represent saving (although see Engelhardt 1999 for an analysis that includes this point). They may understate the importance (as opposed to the magnitude) of the retirement income loss, however. Households that tend to cash in LSDs, households for whom pensions are most likely to represent additional saving (see Gale 1998), and households that tend to be saving inadequately (see Engen, Gale, Uccello 1999) share similar characteristics. They tend to be younger, less educated, lower-income.