You have a client who participates in a defined benefit pension plan at work. She's near retirement, and needs to make a decision: take the money as a lump sum, or receive a monthly lifetime annuity-style payment? What advice should you give?
“Take the lump sum and run,” might be your first inclination. After all, much of the news we read about pension plans sounds pretty bad. Public sector plans are under-funded, and private employers are freezing or terminating plans. American Airlines recently filed for bankruptcy, proposing to terminate its four plans and turn them over to the Pension Benefit Guarantee Corp., (PBGC); it would be the country's biggest-ever pension default, affecting 130,000 workers.
Plan sponsors don't always offer a lump sum option, and they are prohibited by law for plans that fall below certain funding levels. But even if a lump sum is a choice for your client, think twice before advising a client to take it. It's important to get past the headlines to understand what's really going on with defined benefit plans. And, while there's no one-size-fits all answer, most retirees will come out ahead over the long haul by taking their pension as an annuity.
Here are six reasons why.
1-Pensions protect against longevity risk. One of the greatest threats to retirement security is longevity risk – the risk of outliving your money. Since no one can know how long they will live, the only source of protection against this risk is a guaranteed source of lifetime income. Defined benefit (DB) pensions are becoming morerare, leaving Social Security or an income annuity as the other main options. If your client is fortunate enough to have a DB pension, don't be too quick to dismiss the value of its annuity feature.
2-The pension forecasts are too pessimistic. Pension plans are under-funded, but not to the point where you should hit the panic button. The aggregate funding level of corporate pension plans at S&P 1500 companies was 78 percent at the end of January, down from 84 percent a year earlier, according to Mercer. That drop stems from ultra-low interest rates on fixed income portions of portfolios, and from a provision in the Pension Protection Act of 2006 (PPA) that requires use of a more conservative discount rate to project portfolio returns. But plans have assets on hand to pay benefits for years to come – and plenty of time to recover from funding gaps.
The extent of underfunding among public sector plans is a subject of debate. Some experts argue that funding levels should be measured using a very conservative “riskless rate of return” based on bond returns; others argue that historical rates of return – including equity investments – is more appropriate.
But despite what you read about basket-case public sector plans, it’s important to remember that most government-sponsored pensions are guaranteed by state law. Unlike the private sector, pension rights can’t be easily changed or revoked. So pay attention to the fiscal health and legal situation of your client's plan — and especially the discount rate assumptions that are being used to project its future health.
3-There is a Plan B for private sector plans. Some retirees worry that their pensions won’t be there for them if their employer gets into trouble. But most private sector plans are insured by the PBGC, the federally-sponsored agency that insures most private sector plans through premiums paid by plan sponsors.
When that happens, PBGC pays most workers 100 percent of what they earned up to the point of the plan's termination. That means a worker ready to retiree—or already retired—is made whole, although younger workers would miss out on remaining years of benefit accruals.
PBGC payouts are capped by law, so very high-earning workers (like airline pilots) wouldn't receive 100 percent of their benefits. The cap is determined using a formula based on age at the time the plan is terminated, and it is updated every calendar year. For 2012, the maximum monthly benefit for workers retiring at age 65 is $4,653.41, or $4,188.07 if you elect a joint and survivor option that pays benefits to a spouse.
If your client participates in a multi-employer pension plan, guarantees are much lower due to differences in the insurance plan design and premium levels. Currently, it's set at $1,072 per month.
4-Lump sum formulas aren't favorable. Pension plan sponsors calculate lump sums using longevity and interest-rate factors, aiming to match the amount that a pensioner would need to invest to match annuitized payments. In that sense, the choice between lump sum and annuity should be neutral, producing the same result over time.
But in fact, most people will come out ahead with an annuitized pension.
A key reason is a revision in lump sum calculations mandated under the PPA. The change—which was sought by plan sponsors—changed the benchmark interest rate used to calculate lump sums. They argued that lump sum payments—which move inverse to interest rates-- were being inflated artificially by ultra-low, 30-year Treasury rates. The PPA replaced the Treasury rate with a higher composite corporate bond rate that has been phased in fully as of this year. The corporate rate is a little over 100 basis points higher than the Treasury rate.
“All other things being equal, it means a lower lump sum,” says Alan Glickstein, a senior consultant and pensions expert at Towers Watson. “For someone close to retirement age, it works out roughly to a 10 percent change in value for every one percentage difference in interest rates.”
5-Women get an especially bad deal. The actuarial tables governing lump sum calculations are unisex, but women outlive men, on average, by about four years. That means female workers who take lump sums get shortchanged.
6-Early retirement can be a pothole. Many employers offer older workers pension incentives to retire early, but they aren’t required by law to include those sweeteners for workers who take lump sums.
None of this is to say there are no circumstances where a lump sum makes sense. “You need to have an understanding of the individual's needs,” cautions Glickstein. “The key question is, what will the money be used for, and how much of the person's retirement income does it represent.”
Mark Miller is a journalist and author who writes about trends in retirement and aging. Mark edits and publishes RetirementRevised.com, featured as one of the best retirement planning sites on the web in the May 2010 issue of Money Magazine. He is a columnist for Reuters and also contributes to Morningstar and the AARP Magazine. Mark is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living (John Wiley & Sons, 2010).
