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.

Pension Reporting: The Differences Between a 10-K and Form 5500

Institutional investors, retirees, corporate stockholders, and regulators all have a need to closely monitor pension fund performance. There are two leading sources of publicly disclosed information for public company pensions, the Form 10-K and the Form 5500. This article reviews both data sources and compares the information found in each.

Pension Reporting on an SEC Form 10-K

The Form 10-K is an annual report that public companies must file with the U.S. Securities and Exchange Commission (“SEC”) within 75 to 90 days after the end of the firm’s fiscal year, depending on the size of the company and the length of time they have been public.

The 10-K provides a comprehensive overview of the company’s business and financial condition and, most importantly, includes financial statements that have been audited by an independent accounting firm. The 10-K is not to be confused with the glossy “Annual Report to Shareholders” booklet that a company must send to its shareholders when it holds an annual meeting to elect directors.

The SEC requires that each Form 10-K must include specified disclosure sections. The items of particular interest to institutional investors, retirees, and other pension watchers will be the following:

Item 6. Selected Financial Data.

Investors will typically find a detailed Five-Year Financial Summary contained in table format in Item 6. This section gives an overview of the firm’s financial performance, but may or may not include much detail on pension obligations.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

In this section the management team may discuss pension expenses, net pension liabilities, accounting for pensions, postretirement benefit obligations (including retiree medical plans), cash contributions to the pension plan, and unfunded pension obligations.

The footnotes to the financial statements contained in the Form 10-K can be a source of valuable data on pension obligations. For example, the footnotes are likely to disclose the firm’s “Significant Accounting Policies and Estimates” including the following in regard to pension and welfare plans:

  • Average return on assets
  • Expected rates of return on pension plan assets
  • Health care cost trend rates
  • Minimum pension funding requirements, by dollar value, by year for the next five years
  • Projected and accumulated benefit obligations

Projected pension liabilities, as reported in the 10-K, typically include projections over time. The liability number reported in the 10-K is generally a much larger amount than information contained in the Form 5500.

Pension Reporting on a Department of Labor Form 5500

The Form 5500 is an annual report that must be filed by employee benefit plans with the Department of Labor (“DOL”). The form was developed jointly by the DOL, the Internal Revenue Service (“IRS”) and the Pension Benefit Guaranty Corporation (“PBGC”) to achieve reporting disclosure and compliance under Title I and Title IV of the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code. A Form 5500-SF is a comparable annual return modified for use by small employee benefit plans.

A single completed Form 5500 can total dozens of pages of data once all the required attachments are considered. Various schedules are used with the Form 5500, including:

  • Schedule A – Insurance Information
  • Schedule C – Service Provider Information
  • Schedule D – DFE/Participating Plan Information
  • Schedule G – Financial Transaction Schedules
  • Schedule H – Financial Information
  • Schedule I – Financial Information – Small Plan
  • Schedule MB – Multiemployer Defined Benefit Plan and Certain Money Purchase Plan Actuarial Information
  • Schedule R – Retirement Plan Information
  • Schedule SB – Single-Employer Defined Benefit Plan Actuarial Information

Form 5500 always focuses on a benefit plan’s current liability, never on projected benefits. It provides an overview of the plan’s funding status in various ways.

Schedule H includes an asset and liability statement reporting the fund’s financial positions at the beginning and the end of the year. An income and expense statement must also be included. The plan sponsor must identify any changes in net assets for the year, as well as income or expenses for any trust(s) or separately maintained fund(s) and any payments/receipts to/from insurance carriers.

Identification of each person or entity who received, directly or indirectly, $5,000 or more in total compensation (I.e., money or anything else of monetary value) in connection with services rendered to the plan or the person’s position with the plan during the plan year must be identified. This could include fund managers, accountants, actuaries, etc.

Form 5500 filings are publicly available at the Department of Labor’s website by looking for the “Form 5500/5500-SF Filing Search” feature.

Comparing the SEC Form 10-K with the DOL Form 5500

Many institutional investors ask how they can reconcile the pension and benefit information contained in the SEC’s Form 10-K with the Form 5500 DOL filing. The simple answer is that the data sets are different and are not intended to be reconciled.

The information contained in each document is correct, even though it is different, and companies are not trying to mislead investors with the separate data sets. From a regulatory standpoint, plan sponsors are required by law to disclose different views of pension liabilities to multiple audiences in varying formats.

The Form 5500 is particularly informative because it requires disclosure of the liability amount that must be funded at the present time. This number tells investors what the benefit obligation is now, including the extent to which current liabilities are funded. Industry guidelines generally consider a plan with a funded ratio of 80% or better to be healthy, although the American Academy of Actuaries points out that it is important to understand how a pension obligation is measured.

As mentioned above, the Form 10-K differs from the Form 5500 in that the 10-K includes projections of liabilities in future years. For this reason, the pension obligation reported in the 10-K is frequently much larger than the number reported in the Form 5500.

In summary, it is important for interested parties to read all disclosure data about a pension and benefit plan. Additionally, institutional investors and others will want to understand how the data is derived and how it can be reasonably interpreted.

ERISA Benefits Consulting, Inc. by Mark Johnson provides benefit consulting and advisory services and does not engage in the practice of law.

© ERISA Benefits Consulting, Inc.

August, 2014

A Few Facts About Pension Schemes

With the state pension yielding just over £10,000 per annum, it is becoming unthinkable not to have another means of income for retirement. There are several ways to back-up the pension scheme and in doing so, it is possible to have a little more financial security.

Start Saving Now The sooner a pension is paid into the better. It is much better to start one at twenty than it is at forty, as thanks to compound interest the twenty quid a month invested when you were twenty is worth a lot more than twenty quid at retirement age.

How Much Should I Contribute? The simple answer is as much as you can afford. However, it is worth considering other forms of savings as well for retirement, such as stocks and shares ISAs. Many financial advisors do not believe in having all the money tied up in one place. So if you can pay £100 per month, perhaps split it between a pension and other investment vehicles such as the stocks and shares ISA.

Work Related Pension Schemes Work related pension are moving away from final salary pension schemes which guaranteed your pension based on your years of service. The alternative is money – purchase plans or defined – contribution schemes. Your employer will contribute a certain percentage to your pension, which typically is fairly low. Some companies however, will offer between 5-15%. Nonetheless, it is free money and should only be turned down if you have a much better alternative somewhere else.

Work past Retirement Age Though it is not a suggestion that currently sits well with unions, if you feel your pension pot is not going to be enough, you can always choose to work longer. This does not have to be a full time position, as lets face it by this stage you will be getting on a bit and probably want to enjoy life a little more. Whether you want to continue in your present role or switch to another is irrelevant as far as the pension pot is concerned as the pressure to live off it has diminished.

Taking Control Whether you have an occupational pension scheme or a private pension scheme you still have a measure of control allowing you to contribute more if you choose to. The Self – Invested Personal Pension scheme (SIPP) is a popular choice for people that either cannot join a workplace scheme or wish to run both a private pension scheme and an occupational scheme at the same time.

The pension scheme despite its bad press is still a necessary financial investment. If you are considering a pension scheme, then it pays to shop around.