Conscientious Financial Planning and Retirement Income Management | 201-741-9528
from Lonier Financial Advisory LLC, Osprey, FL

Taking Your Lumps

Taking Your Lumps

Pensions buyouts and transfers are in the news (again). Corporate America is restructuring its growing underfunded pension commitments. Ford, GM, NCR, The New York Times, Visteon, Archer Daniels Midland, Thomson Reuters, Equifax, A.H. Belo, and Yum! Brands have all made buyout offers to tens of thousands of current and former employees vested in company pension plans in efforts to lighten their pension liabilities(1).

Some, like GM and Verizon, are also transferring pension obligations to group annuity deals with insurers like Prudential. AT&T is transferring $9.5 billion in preferred equity to its pension fund, to address its $10 billion unfunded liability, preserving its cash (and creating the kind of risk for all its pensioners that individuals should avoid by owning too much of their employer’s stock!).

The 401(k) do-it-yourself-retirement revolution is entering the home stretch. According to a Towers Watson report last week, only 30 of the Fortune 100 still offer pension plans to new hires. In 1985, the number was 90 out of 100, with only 10 offering 401(k) plans, which first went into effect in 1980.

Of course, the old Fortune 100, which was mostly Big Manufacturing, isn’t what it used to be either. The high tech companies who have supplanted the old rust-belt firms were never big on employee benefit plans, instead pushing perks like Friday beer parties and housecleaning for employees who slept under their desks like the young Steve Jobs. With a chance to win big in the tech startup lottery, who needed the old-fashioned security of a pension plan!

A Significant Role in Your Retirement Income Plan
Social Security and pensions are shrink-wrapped secure retirement income—bedrock income flooring—with lifetime benefits for you and, depending on the options available in your pension plan, possible continuing survivor benefits for your spouse.

Even if you don’t have a pension or are not offered a buyout, you will likely face the decision of whether to take a lump sum payment or opt for a lifetime stream of income from your 401(K) when you stop working—so pay attention!

Like the strategy for claiming Social Security benefits, the choice between a lump sum or lifetime income stream can make a critical difference to your lifestyle in retirement—tens of thousands of dollars over the years.

You need secure income flooring in retirement to at least cover your essential expenses such as housing, food, clothing, transportation, healthcare, and insurance. Your savings and investments, ideally, should be for emergencies and discretionary/legacy goals.

Almost everyone needs more secure income than they will receive from Social Security, and possibly even more than Social Security plus any pension, so be cautious about converting a pension to cash. You can find out more about retirement planning and determining how much secure income you need from my continuing series on Lifetime Financial Planning, available here (“What Is Retirement Income Planning?”).

Considerations For Taking Your Lump
Let’s start with the assumption that you need the pension income stream as part of your essential retirement income floor.

With that assumption, there are just a few reasons why you should consider the lump sum offer instead of regular pension payments:

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  • You are in poor health and not expected to live much longer and you do not have a surviving spouse to provide for or your pension does not have survivor benefits
  • You have substantial assets with a very favorable coverage ratio for your expected retirement expenses, are an experienced investor, the loss of some or all of the principle from investing the lump sum would not impair your financial situation, and you prefer to manage the lump sum value of your pension yourself or are willing to pay an investment manager 1-2% a year to do it for you
  • Your pension significantly exceeds the $55,840 annual amount covered by the federal Pension Benefit Guaranty Corporation (PBGC), your company is likely to fail, and its pension plan is seriously underfunded and is also likely to fail
  • You can buy a larger secure income stream with the lump sum than your pension would pay; a number of companies have used new rules allowing a higher interest rate to calculate lower lump sums than previously allowed, so you should check this out, as explained below

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The first reason, very poor health, either applies or it doesn’t. Same with the second, you either have more than enough or you don’t.

The third reason depends—no one can predict the future. If you fear that 20 years into retirement your ex-company will fail, its pension plan will fail, and the self-sustaining PBGC will be on its last legs and unable to make good on the $55,000 + increases that it insures for pensioners, then consider what might happen to the lump sum you take now because of this fear.

The lump sum is a large sum of money, so you will need to park it somewhere. If you invest the lump sum, it will be subject to an even larger set of investment risks than your pension plan during that same long-term time period—business risk, market risk, regulatory risk, credit risk, currency risk, interest rate risk, inflation risk, etc. You could lose some or all of it in the markets.

In other words, the pension is insured, and the lump sum, exposed to more risk, is not.

At this point in your life, you should be de-risking, moving out of the markets, and increasing your secure income floor, not pulling it up to move cash into the markets. A pension or an annuity is secure, guaranteed income. Market returns are not.

That leaves the last of the four reasons as the main consideration for most of us.

Take the payout only if you can buy a bigger pension. Unless you are dying or so wealthy it really doesn’t matter, the main reason to take the lump sum instead of the pension is if you can use it to buy a larger, insured “pension” yourself, ie, a single-premium immediate annuity. The same thing GM, Verizon, and other large corporations are doing with their entire pension plans.

Can You Buy A Bigger Pension?
Here’s a simple way to find out if you can buy a bigger pension. The example spreadsheet below shows a case where someone has been offered a $700,000 buyout for a $50,000 annual pension.

The annuity quotes shown are from the Vanguard website, which offers low-cost single-premium immediate annuity (SIPAs) quotes from a number of highly rated insurance companies through an arrangement with Hueler Investment Services. These low-cost annuities bear roughly the same relationship to more controversial and risky high-cost variable annuities that term insurance has to costly variable life insurance. SIPA’s are a low-cost, low-risk way to add to your secure retirement income floor.

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The chart shows that for a 65 year-old male, a $50,000 annual annuity costs $773,000 and for a 65 year-old female, who statistically will live longer than the male, the cost is $825,000. In other words, in this case the company is offering 10% —$73,000— less than the cost for a male to replace the pension with an annuity.

Yes, $700,000 is a big chunk of change. But in this case, it’s not big enough—it’s at least $73,000 short of being a wash.

If the lump sum is significantly higher than the cost of a comparable annuity, then take the lump sum, and either use it all to buy a bigger annuity than your pension (which is a good thing!) or buy the replacement annuity and bank the rest. And count yourself very lucky—your company is probably not offering such a favorable deal.

If the lump sum and the cost of the annuity are about the same, then the relative business risk of your pension plan vs. the annuity insurance company, and the size of your annual pension relative to PBGC coverage may come into play.

Your company is probably not giving you a bonus, but you should go through this exercise to find out if they are. It will at least help you better understand the value of your pension, especially when someone is waving a big gob of money at you to make it go away.

You can download the spreadsheet here and plug in your pension amount on line  5 and the buyout offer on line 19 and see how it plays out. Keep in mind that the effective interest rate for annuities constantly changes and the 6.5%/6.11% shown now will go up and down and the current rate could be different, so you should get a current quote when you do the comparison if your leaning strongly towards the buyout.

Not The Only Way To Build Secure Retirement Income
There are other kinds of secure income floor besides single-premium immediate income annuities—ladders of Treasury bond STRIPS or TIPS, for example. Or highly-rated muni bonds in taxable accounts. The current low-yield environment favors the immediate annuity, so we’ll stay with that in this discussion for simplicity, but during retirement income planning, various secure income flooring options should be studied.

I’m not an insurance agent and I don’t work for a large asset management firm or bond dealer, so I don’t have any particular ax to grind—I’m not pushing annuity insurance products or stocks and bonds. From my fiducial viewpoint as a retirement management analyst, these are all tools that in some combination can be used to create a plan that best aligns with your household financial situation to provide a secure retirement lifestyle for you and your family.

It’s in your best interest to work with someone who is not biased by the products they sell and who is also knowledgeable about lifetime retirement income planning, and not just steeped in risk management with insurance products or building asset value through portfolio management. You need the whole picture.

You can find additional information about lump sum pension buyouts here from the Pension Rights Center.

As always, if you have any questions, don’t hesitate to contact me via email or phone, 201-741-9428.

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