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Is your client about to take a gold watch and call it a day, retiring after 40 years? Did their employer dangle several appealing options regarding pension benefits?
Stop!
Don’t let your client make a move until you’ve carefully considered the issues and implications of each option. You may find better ways for your client to realize pension benefits.
Should a client decide to take the lifetime-pension option, they now must choose between one of several payout options. If they are single, the choice is simple. Take the single-life payout option in order to secure the highest monthly lifetime income.
But if your client is married, it gets more complicated. Should they take the highest payout that ends at death with no residual pension benefit for the spouse? With this option, your client’s spouse could be left out in the cold with nothing.
If, on the other hand, your client chooses the option that provides 100% survivor benefit, they sacrifice a large chunk of their monthly pension check. And here’s another potential problem that you may not have considered; your client may not die first. If your client’s spouse passes away before your client does, and your client has chosen the lowest payout with 100% survivorship, your client has now sacrificed an added pension benefit.
Sadly, there are no “do-overs” after these decisions are made.
Just when you thought things were getting complicated, the employer throws another curve ball. Instead of a lifetime-pension benefit, they offer a lump sum of money instead. This has become increasingly popular with companies for reasons I’ll discuss later. Should your client take the money? Or should they take the monthly paycheck for life?
Let’s break down the issues and bring a little clarity to the options.
Survivorship options
First, let’s consider the survivorship options and see if there are some alternatives available to your clients. Quite often, there are more survivorship options given by employers than the ones mentioned here, but we’ll confine ourselves to these basic options for simplicity’s sake. Assume the employer has offered the single-life with zero-survivorship option. Taking the single-life option ensures the highest payout while clients are living, but nothing for spouses at death. On the other hand, a limited (25-75%) or full (100%) survivorship option means potentially sacrificing a significant amount of monthly income. This sacrifice will be in vain if a client’s spouse dies first.
There is a third option called pension maximization, or pension-max, for short.
Under pension-max, your client opts for either no survivorship or limited survivorship options. They take the added amount over what they would have received for the 100% survivorship option and purchase life insurance on themselves. Their spouse can then receive either a lump sum or annual death benefit to make up for the lost residual income at death. As an example, let’s assume that your client’s full benefit with no survivorship option is $1,500 per month. The payout for the 100% survivorship option is $750 per month. Under pension-max, your client would opt for the first option and take the added $750 (or a lesser amount, depending on age and health) to purchase a death benefit that will replace the lost pension income at death.
As a financial advisor, you should analyze the pension-max option to determine if it would benefit your client and spouse. There are several important variables to consider -- including the client’s and spouse’s age, health, insurability and life expectancy. Does your client have good genes? Did their relatives live long lives, or did they die prematurely from some inherited condition? In addition, consider the cost of insurance, your client’s tax bracket in retirement years and whether any health care benefits from their employers are tied to your client’s pension.
Lump-sum versus lifetime-annuity options
Recently, more companies are offering the lump-sum payout option to their retirees in lieu of income for life. Why is that? Pensions were at one time the de facto retirement benefit offered by companies to promote employee loyalty. Over the past 20 years, however, that trend has reversed. Rather than offer lifetime pension benefits (also known as defined benefit plans), companies have begun offering either newer and leaner “cash balance plans” or defined contribution plans like 401(K)s or 403(B)s.
These plans, first introduced by an act of Congress in 1978, have become increasingly popular while defined benefit plans have become the modern equivalent of the corporate dinosaur. According to Moshe Milevsky, finance professor at York University in Toronto, Canada and a noted expert in North American retirement planning, this might be partly because 82% of defined benefit (pension) plans in 337 of the S&P 500 companies were under-funded as of 2006.
Along with this, lower interest rates have only made it more difficult for companies to meet their liabilities, and people are living longer. 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 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. This will make it more expensive to maintain these plans and further exacerbate unfunded liabilities.
Companies assume all the investment risk for benefits provided through defined-benefit (DB) plans, whereas the employee assumes all investment risk with defined-contribution plans. In addition to closing DB 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 (including consumer credit rates and fixed-income yields) are near historic lows because of the Federal Reserve Bank’s monetary policies. This offers both an incentive for companies and an opportunity for the soon-to-be retiree.
With the passage of the Pension Protection Act in 2006, funding mechanisms were scheduled to change over a number of years from calculating funding requirements based on long-term Treasury rates to a mechanism based on 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 U.S. Treasury and 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 clients. Companies may be willing to offer a higher payout today than they will in a few years. If future interest rates return to more normal levels, employers may then be able to offer a lower lump-sum settlement in lieu of the lifetime-pension benefit.
In addition to this carrot, there is a possible stick to consider that might push clients toward choosing the lump-sum payout option. In the latest omnibus bill, Congress passed legislation to take the heat off of some 1,400 financially distressed multiple-employer benefit plans in danger of defaulting on pension obligations. Rather than throwing the burden on the grossly underfunded Pension Benefit Guarantee Fund, these plans can 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 is 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 preventing companies with single-employer plans from seeking shelter under similar legislation?
Clients must consider whether they can take a lump-sum offer and create more income than with their pension. That depends on several factors. How important is the monthly payout to meeting required monthly expenses after subtracting income from Social Security and other sources? If it is very important, then how confidently can they take the lump sum and produce the same or more income than they could by taking the monthly payout?
Let’s break down the options by first determining how much money a client could produce on their own. Let’s say that the monthly payout for both your client and their spouse is $2,500 a month, or $30,000 annually. In lieu of this, the company offers a lump sum of $600,000. In order to produce this much income, your client would need to earn 5% on the principal.
The S&P 500 index has enjoyed an average return of 7.3% over the past 10 years, and 9.2% over the past 20 years. If your client achieved those results, they would definitely come out ahead. But one need not look back far to remember that it’s also possible to lose 40% or more of portfolio value due to market downturns like those experienced in 2008-2009.
If your client is averse to this kind of risk, consider some type of single-premium immediate annuity (SPIA) or deferred- income annuity that could produce the same or better income payouts without market risk. Many of these products offer the same guarantees along with greater flexibility than that offered through a company’s group annuity (e.g., monthly income).
Neal Angel is president of AngelRoyce Wealth Advisors, LLC, a registered investment advisory firm in Greenville, South Carolina. Neither AngelRoyce or its affiliates offer tax or legal advice. To respond to this article, email Mr. Angel at [email protected].
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