How To Handle Your Pension Options

Over the years one common choice I have seen clients faced with is whether or not to opt for a lump sum pension benefit when it is offered to them at retirement versus accepting the monthly annuity payment from the company. Let me first start by saying that for those individuals who are employees of a gov’t agency...this will not likely apply to you, as a lump sum option is typically not a choice you will be offered. However the remaining members of the private sector who may find they are facing such a choice may want to further explore their options in detail.

It has become more common for those in the baby boomer generation, whom have worked for large multinational corporations and even sum mid-sized businesses to be given the option at retirement to take either a monthly payment or the commuted value of that payment in a lump sum amount. This is largely due to the longer than expected life expectancies we are facing as well as other demographic changes that can impact the actuarial projections of a pension fund. It is simply very difficult to predict in a pension fund what these legacy costs will be due to a variety of reasons. Companies may have a smaller number of employees in the future contributing to the fund. They may have slower than expected business cycles that force layoffs and reduce staff. So as a result, there is and will continue to be more of a push towards defined contribution plans (401k/profit sharing) in the future.

Many employees are upset with this and don’t realize this can work out better for them as long as they are disciplined savers. First off, it is important to understand some basics about how a pension fund works. It is a “Defined Benefit” plan. This means that there is a projected collective income it needs to meet in the future to pay for the current and future beneficiaries. Those projections dictate not only annual contributions to the plan, but also the investment allocation applied. If you happen to be in a certain demographic that differs from that of the rest of the group, your proportionate allocation of the pension fund may be invested too aggressively or conservatively for your age and financial goals. Yet you have no control over this. When participating in a 401k/profit sharing plan, you have the ability to exercise far greater control over the investment strategy. Granted this means you have to be more involved in your financial affairs. However, that is a good thing. Not all pension funds are managed in a cost effective way. Not all have trustee’s that make sound investment choices. And not all remain solvent.

Solvency is a key issue. If you are a participant of a pension fund, the only real guarantee you have is through the Pension Benefit Guarantee Corporation (PBGC). However PBGC only secures 100 percent of the first $11 monthly payment per year of service and 75 percent of the next $33 monthly payment per year of service. These numbers are adjusted for inflation each year. Pension funds can and do go bankrupt. It happens more often than most workers realize. On the contrary, your 401k plan, while subject to the same market risk on investments that the pension fund is also subject to, remains 100% yours once you’ve become vested. That at a maximum is likely to be six years of service with your employer.

What about a fixed income ??? Why would you take a lump sum when offered if you are someone who simply wants the comfort of the fixed monthly payment ??? The answer here is simple. Let’s assume your employer is offering you at age 65 retirement…$3,100.00 per month or a $500k lump sum to be rolled to your IRA. If you opt for the lump sum, you still have the monthly payment option. You can simply work with a financial planner or on your own contact and insurance company and receive a quote for what is known as an “Income Annuity”. There are many versions of annuities and many are not in your best interest. However a standard traditional immediate income annuity is simply a private pension plan.

An immediate annuity can have various benefits over that of a traditional pension. In general insurers are required to keep an adequate amount of reserves to fund their liabilities in the future, which is routinely audited by the states insurance commissioners office. Unlike a private pension, which will be subjected to the demographic shifts of the companies labor force, an insurance company can control the demographics through their sales. Should more people die sooner than expected, they see greater than expected losses on their life insurance sales, yet they save money on the firms annuity sales. Should more of the population live longer than expected, the inverse would be true. The only thing the insurer needs to do is balance the sales between the product lines. During the peek of the 2008 financial crisis, the worlds largest insurer AIG was nearly put out of business. However, many were totally unaware that their insurance liabilities were properly segregated and fully funded. So while stockholders took sizeable losses, the insured who owned policies were never in jeopardy.

Another such benefit is depending on your state there may be a guarantee beyond that of the insurer. For example in the state of New York, the Life Insurance Company Guarantee Corporation of NY will secure 100% of that payment in the event of a default of the insurer up to $500k per insurer. If your lump sum is larger than $500k, you can issue separate contracts with different issuers. This is a signficantly higher guarantee than that which is offered by the PBGC in the event of a pension fund which is taken into receivership.

What about the payment ??? The actuarial data used by insurers is largely the same. So the difference in monthly payments will differ only slightly from one company to the other. And for the same reason the payment is usually comparable to the amount offered in the monthly payment by the pension fund at a traditional retirement date. Additionally the tax treatment is the same.

Furthermore, with a pension fund from an employer there may be an option for a survivor benefit to the spouse at a reduced rate. However many pension funds offer no continuing benefit to children or other beneficiaries. I once had a client of mine pass away 2 week before his retirement date. He and his spouse were quite close and she was so distraught by his passing that she died 1 year later. Sadly his company never offered a lump sum option. So after nearly 40 years of working for the same company, his wife received one year’s worth of monthly benefits and the rest was a forfeiture reallocation to the pension fund. Simply put, the kids inherited NOTHING !!! When I calculated the commuted lump sum value of the benefit based on what the spouse was receiving, it was in excess of $700,000.00. And nearly all of it went back to the company pension fund for the other participants. However, with a private annuity you can and likely should choose a period certain. For example, you may opt for a 20 year period certain. This means the payments will continue on a last to die basis. Simply put, as long as one of your are alive the pension payments go on. However, should both of you pass on earlier than anticipated, the remaining number of the 20 years will go to a stated beneficiary. This type of benefit does little to reduce your monthly payment since the insurer is already determining the benefit on the assumption that you will live a normal life expectancy. Most importantly, the benefit stays in the family.

Lastly, what if using the reference above, you did not need $3,100.00 per month at age 65. Perhaps because of social security and other income sources you really only need $1,000.00 per month. That would mean you would likely only need to buy $180k or so worth of an income annuity. You can still roll the remaining $320k into your IRA to grow it on a tax deferred basis for your future income, or leave it to your heirs. The point is simply flexibility. When you’re participating in a 401k/Profit sharing plan you have far greater control. You need only be a disciplined saver and have a sound plan in place. Yet, the option for the defined benefit still exists through a private insurer in a full or partial amount.

In summary these are just a few of the various options available to you, and you should consider all of them. Perhaps even consult with a financial planner on the matter before deciding. But don’t assume because employers are doing away with pension funds that they are not still available to you. In many cases the employer may be contributing just as much if not more to your overall retirement on an annualt basis, and is simply passing on the responsibility to you of managing the asset yourself. This means each employee needs to be more aware of their financial situation and take the time to properly educate themselves on the options available.