Options You Need to Consider Before Making An Irrevocable Pension Decision

So you are getting ready to take the gold watch & call it a day on the last forty years of your working life. On the way out the door, your employer dangles several appealing options regarding your pension benefit. Stop! Don’t make a move until you’ve carefully considered the issues & implications for each option. You may just find that you have options that you hadn’t considered when it comes to your pension benefit.

Should you decide to take the lifetime pension option, you now must choose between one of several payout options. If you are single, the choice is simple. Take the single-life payout option in order to secure the highest monthly lifetime income. But if you are married, it gets more complicated. Should you take the highest payout that ends at your death with no residual pension benefit for your spouse? Choose this option, and your wife could be left out in the cold with nothing after you’re gone, and struggle to pay the bills the rest of her life. If, on the other hand, you choose the option that provides 100% survivor benefit, you sacrifice a large chunk of your monthly pension check. But here’s another potential problem that you may not have considered. Statistically speaking, most husbands die before their wives. But what if your wife dies first, and you have chosen the lowest payout with 100% survivorship under the assumption that you would be the first to go? You have now sacrificed the added pension benefit that you could have received for the remainder of your life. Sadly, there are no “do-overs” when you make your decision. Bet you hadn’t thought of that, had you?

Just when things were getting complicated, your employer throws another curve ball at you. Rather than taking a lifetime pension benefit, he offers you a lump sum of money instead. This has become increasingly popular with companies for reasons we’ll discuss later. Should you take the money & run? Or should you take the easy way out, and go with the monthly paycheck for life? After all, this is the closest thing to the security of a paycheck while you were working.

And you thought retirement was going to be easy, didn’t you? Heck, this is too much like work. Rather than get all wrapped around the axle, let’s break down the issues & bring a little clarity to your options.

SURVIVORSHIP OPTIONS – First, let’s consider the survivorship options, and see if there are some alternatives available to you. Quite often, there are more survivorship options given by your employer than the ones mentioned here, but we’ll confine ourselves to these basic options for simplicity’s sake. First, your employer has offered the single-life with zero survivorship option. Taking the single-life option ensures the highest payout while you are living, but nothing for your spouse at your death. On the other hand, choosing either a limited (25-75%) or full (100%) survivorship option means potentially sacrificing a significant amount of monthly income for you. To add insult to injury, you may penalize yourself if your spouse dies before you. Perhaps there is a third way. As a matter of fact, there is. It is called pension maximization, or pension-max, for short.

Under pension-max, you opt for either no survivorship or limited survivorship options, then take the added amount over what you would have received for the 100% survivorship option, and purchase life insurance on yourself so that your spouse can then receive either a lump sum or annual death benefit to make up for the lost residual income at your death. As an example, let’s assume that your full benefit with no survivorship option is $1500 per month. On the other hand, the payout for the 100% survivorship option is $750 per month. Under pension-max, you opt for the first option, then take the added $750, or some lesser amount, depending on your age & health to purchase a death benefit that will replace the lost pension income at your death.

Before choosing the pension-max option, it is vitally important that you talk with a financial advisor who can help you crunch the numbers in order to determine if this will benefit you & your spouse. There are several important variables to consider that may determine if this strategy makes financial sense for you, including your age, health & insurability, the age & health of your spouse, along with the life expectancy of both you & your spouse. Do you have good genes? Did your extended family members live long lives, or did they die prematurely from some inherited condition that is likely to affect how long either you or your spouse are likely to live? In addition, you need to consider the cost of insurance, your tax bracket in retirement years, and whether any health care benefits from your employer are tied to your pension. These are things that an experienced financial professional can help you sort out.

LUMP SUM VERSUS LIFETIME ANNUITY OPTIONS – Recently, more & more companies are offering the lump sum payout option to their retirees in lieu of income for life. Why is that? A little context might be helpful. Pensions were at one time the de facto retirement benefit offered by companies as a way to entice loyalty on the part of their employees. During the past twenty years, however, that trend has reversed. Rather than offer lifetime pension benefits (also known as defined benefit plans), companies began closing these plans to new members & replacing them with either newer & leaner “cash balance plans”; or alternatively, with defined contribution plans, also known as 401(K)s or 403(B)s (for employees in non-profit organizations). These plans were first introduced by an act of Congress in 1978, but have become increasingly popular, while defined benefit plans have become the modern equivalent of the corporate dinosaur. Why is that? According to Moshe Milevsky, finance professor at York University in Toronto, Canada, and a noted expert in North American retirement planning, 82% of defined benefit (pension) plans in 337 of the S&P 500 companies were under-funded as of 2006. When you combine the fact that lower interest rates since then have only made it more difficult for them to meet their liabilities, along with the fact that people are living longer these days, it’s easy to understand why companies might want to shift this risk off of their balance sheets and onto the balance sheets of their employees. In addition, the cost of insurance for companies participating in the Pension Benefit Guarantee Corporation insurance program is scheduled to increase by between 30-50% in 2015, with even more increases proposed for 2018, making it more expensive to maintain these plans, and further exacerbating their unfunded liabilities.

It’s important to understand that your company assumes all the investment risk for benefits provided through defined benefit plans, whereas the employee assumes all investment risk with defined contribution plans. In addition to closing plans to new members, many companies have also attempted to further avoid the risk to current plan members by offering lump sum payouts. After all, we are living in a time when interest rates (both defined by interest rates we pay for things like mortgages & cars, as well as interest rates that the Feds pay on Treasury Notes to investors) are at near historic lows because of the Federal Reserve Bank’s monetary policies. This offers both an incentive for companies & an opportunity for you as the soon-to-be retiree. Back in 2006 with the passage of the Pension Protection Act, funding mechanisms were scheduled to change over a number of years, from calculating funding requirements based on long term Treasuries over to the higher paying (and higher risk) corporate bond rates in an effort to lessen the burden to these companies for plan benefits. Even so, since 2006 we’ve seen interest rates on both US Treasuries & corporate bonds fall to historic lows. For this reason, companies must now set aside more money at today’s low interest rates to cover their pension liabilities. This presents a unique opportunity for you. Your company may be willing to offer a higher payout today than it will offer in a few years to get you to accept their offer. If future interest rates return to more normal levels, your employer may then be able to offer a lower lump sum settlement to you in lieu of taking the lifetime pension benefit.

In addition to this carrot, there is also a possible stick to consider that might push you toward choosing the lump sum payout option. In the latest Omnibus bill, Congress just passed legislation to take the heat off of some 1400 financially distressed multiple-employer benefit plans that are in danger of defaulting on their pension obligations. How? Rather than throwing the burden on the grossly underfunded Pension Benefit Guarantee Fund, they may allow these plans to reduce income benefits to their employees. Indeed, many local governments like Detroit have cut benefits to their retirees in an effort to restructure their shaky financial house, but allowing corporations the same escape option would be a watershed moment for defined benefit plans in the private sector. While the current legislation only affects these multi-employer plans (typically negotiated by unions), the barn door has been opened. What is now to prevent companies with single-employer plans to seek shelter under similar legislation?

So the question you need to ask yourself is this. Can you take their offer & create more income for yourself than you could with their pension? Well, that depends on several factors. First, how important is the monthly payout to meeting your required monthly expenses, after subtracting income from Social Security & other sources? If it is very important to you, then the next question is how confident you feel that you could take this lump sum and produce the same, or hopefully more income than you could by taking the monthly payout. This is more complicated, but let’s break down your options by first determining how much money you could produce on your own. Let’s say that your monthly payout for both you & your spouse is $2500 a month, or $30,000 annually. In lieu of this, your company is offering a lump sum of $600,000. In order to produce this much income on your own, you would need to earn 5% on your principal. (To calculate this, divide $30,000 by $600,000). Can you produce a better result on your own? Again, that depends. You may not feel qualified or even interested in making investment decisions on your own. If you did, you might be able to achieve results similar to those obtained in the Market over the recent history. As an indicator of Market performance, the S&P 500 index-which tracks the performance of the 500 largest corporations in the US-enjoyed an average return of 7.3% over the past 10 years, and 9.2% over the past 20 years. If you achieved those results, you would definitely come out ahead. Over the other hand, you would not need to look back far to remember that it’s also possible to lose 40% or more of your portfolio value due to Market downturns like we experienced in 2008-2009. If you are more averse to this kind of risk, you might want to consider some type of income annuity or deferred annuity that could produce the same or better income payouts without Market risk. Annuities are offered through insurance companies as, you guessed it, a form of insurance. While you buy life insurance to protect your loved-ones against the likelihood of dying too soon, annuities are designed to provide longevity insurance. Many of these products offer the same guarantees, along with greater flexibility than that offered through your company’s group annuity (e.g., monthly income). It definitely pays to talk with a qualified financial professional familiar with these products before making your decision on taking a lump sum payout.