What is a lump-sum conversion?

Defined benefit (DB) pension plans commonly distribute benefits as a monthly payment to an individual from the time of retirement until the individual’s death. This form of payment is called a single life annuity. Participants in DB plans often can choose from multiple types of annuities at retirement, but each of these options result in monthly payments. In some circumstances, benefits are distributed as a single payment rather than in monthly payments—this is known as a lump-sum distribution. This form of payment is generally permitted from plans when the “value” of the annuity is less than $5,000 (an IRS limit) or at higher values if the plan provides for this option.

How do you determine the “value” of an annuity in which future payments are promised for an individual’s lifetime? This determination requires the skills of an actuary and is called a lump-sum conversion. The lump sum value of an annuity may also be called the actuarial present value of the annuity.

In this article, Milliman’s Corey Swarner discusses how actuaries make these conversions by introducing the concepts of present value and expected value.