This week, Gail details some important points to take into account when deciding between a lump sum pension payout and monthly payments.
I'm seeing the light at the end of the career tunnel and trying to decide the best pension direction. I have the option of a one-time lump-sum payment or monthly pension payments.
My previous attempts (albeit small) at investing have not been successful. So no confidence there. Witnessing the recent default of pension plans at major corporations makes me worry about my pension (monthly basis).
You are not alone in feeling overwhelmed at the financial decisions each of us has face as we approach retirement. And although you say you work for a “large defense contractor,” you’re right to be concerned about the security of your pension.
The Pension Benefit Guaranty Corporation (PBGC) is one of those federal agencies most people never hear about unless it’s bad news. Just as the Federal Deposit Insurance Corporation insures bank accounts in the event a bank becomes insolvent, the PBGC insures pension benefits when an employer cannot afford to pay them. So if you’re hearing from these folks, it probably means your company pension has gone up in smoke.
The important thing to understand is that, like the FDIC*, there is a limit to this insurance. Regardless of the benefit you earned under your company plan, if the PBGC has to step in, the maximum pension you can currently receive is $45,600 a year. And that’s only if you retire at age 65. If you retire earlier, you receive even less.
While $45,600 a year might sound pretty good to most folks, for higher paid employees, who are eligible for pensions two or three times that amount, this can be a kick in the teeth. Just ask a retired US Airways pilot how much it hurts to spend your retirement living on 65 percent less income than you thought you had coming.
This month the PBGC announced that 1,108 private companies reported they had at least a $50 million shortfall in their pension plans. In other words, in order to meet their future benefit payments, they should have a lot more money in their plans. The total amount of this “underfunding”? Nearly $354 billion.
By law, a pension plan isn’t required to be “fully” funded. It wouldn’t be a good use of a company’s money to set aside every single dollar it expects to pay someone, say, 25 years from now. But a company does have to contribute enough so that, counting the earnings the money is expected to generate, the plan will be able to meet its obligations when they come due.
However, according to PBGC spokesperson Jeffrey Speicher, “most pension plans are underfunded today.” There are a number of reasons for this. The three-year decline in the stock market and historically low interest rates have reduced the returns plans were counting on to increase their balances. The events of 9/11 and the economic slowdown we saw in 2002 cut into corporate profits, making it harder for companies to come up with the money they needed to contribute to their pension plans.
The situation has been getting steadily worse for the past five years. The following table comes from the PBGC’s own Web site:
Summary of Pension Underfunding Filings
|Number of Plans||221||747||1058||1051||1108|
|Underfunding (in billions of $)||$19.91||$110.94||$305.88||$278.99||$353.73|
Keep in mind that these numbers only include the pension plans that are required to report their underfunding. If a plan’s shortfall is under $50 million, it doesn’t have to notify the PBGC. Speicher says the agency estimates the total amount of pension plan underfunding is $100 billion higher!
Not a single taxpayer dollar is used when the Pension Benefit Guaranty Corporation pays benefits to participants of a pension plan in default. The money comes from the annual insurance premiums every company with a defined benefit plan is required to pay the agency. Trouble is, the PBGC itself is in a serious “underfunding” situation.
As of Sept. 30, 2004, the end of the federal government’s fiscal year, the Pension Genefit Guaranty Corporation had a funding deficit of $23 billion — double the deficit it reported the year before. The four pension plans that USAirways walked away from when it filed for bankruptcy left the PBGC holding the bag for $3 billion in benefits. The agency is currently in the process of taking over $6.6 billion in obligations at United Airlines.
Earlier this year the Bush Administration submitted a proposal designed to put the PBGC on sounder financial footing. Among other things, it wants Congress to increase the insurance premium private pension plans have to pay the agency. It’s been $19 per employee per year since 1991. The Administration wants this increased to $30 per employee.
Event at that price, it’s a bargain. According to Speicher, over the years, the total amount of insurance premiums paid by United Airlines amounts to less than $100 million — just one and a half percent of the dollars the PBGC is now obligated to pay out to the airline’s retirees.
You may be thinking, “My employer is not about to go bankrupt. It’s financially sound. Surely, there won’t be any question of my pension benefits being paid.”
The real kicker is that under current law, you have no way of knowing. “One of the most surprising things about the system,” says Speicher, “is the lack of transparency. The reports that underfunded pension plans must submit are, by law, confidential. Employees and shareholders don’t have access to this information.”
That’s something else the Administration wants to change. Speicher says “the President’s proposal would lift this veil of secrecy and give individuals a real-time, accurate picture of a company’s financial situation.”
So, getting back to your situation, Roger, the first question you need to answer is whether you expect your pension to amount to more than $45,600 a year. If the answer is “no” and you plan to work until age 65, then you should be OK. If your company defaults (most companies get out of their pension obligations when they file for bankruptcy), the PBGC will step in and you won’t notice a difference.
On the other hand, if you are entitled to a benefit of more than $45,600 a year, in Speicher’s words, you “should be aware of the risks.”
A company’s financial health can change very quickly, as the recent experience in the airline industry has shown. And if a firm goes through bankruptcy, even if a buyer comes along, the new owner doesn’t have to assume the bankrupt company’s pension obligations. The steel industry taught us that lesson years ago.
Moreover, once you elect to have your employer pay you a pension, this decision is irrevocable. You can’t change your mind and ask for a lump sum payout if the company starts to experience financial difficulties.
Gary Storie, the “Wealth Advisor” at Citizens’ National Bank, recommends you sit down with paper and pencil and list the pros and cons of taking your pension versus a lump sum.
Among the “pro” arguments for taking your pension, Storie lists the emotional security you get from the promise of lifetime income and the fact that “you don’t have worry about market fluctuations. You know exactly what’s coming in each month.” He says the downside to this is that a fixed income will not keep up with inflation.
For instance, let’s optimistically assume that inflation averages just 2 percent per year. In 15 years you would lose more than 25 percent of your purchasing power. In other words, every $1,000 in pension income you receive today would only be worth about $750 fifteen years from now.
Another negative aspect of pensions, says Storie, is that when you and your spouse die (assuming you opted for a joint/survivor payout), your heirs get zero.
Say you sign up for your pension and immediately head off on a month-long dream vacation with your wife. If you both die while you’re away, there is no payout to your kids from the pension plan.
Apparently, your pension plan gives you the choice of taking a lump sum instead of a lifetime payout (not all defined benefit plans do). If you choose the “lump sum” option, the key is to have your pension administrator transfer the amount you’ve got coming directly to your IRA custodian so that the money will continue to benefit from tax-sheltered growth. (If your employer makes the check out to your IRA, but gives it to you, it’s critical that you deposit it into your IRA within 60 days.)
Storie, who works out of the bank’s branch in Wexford, Pa., says that one of the “pros” of a lump sum rollover is that “you can invest it as you want.”
A rollover IRA also gives you flexibility in terms of withdrawals. If you don’t need income, you can leave the money in the IRA. Once you reach age 70 1/2, you just have to withdraw a minimum amount each year. The opposite is also true: if you need additional income, there’s no penalty for withdrawing it provided you’re at least age 59 1/2. When you die, any money left in your IRA can pass to your spouse, children, or whoever you named as your beneficiary.
Keep in mind there are new protections for IRAs in the bankruptcy law that takes effect in October. An unlimited amount of IRA assets will be shielded from creditors in the event you file for bankruptcy, as long as the money came from a qualified retirement plan. (Take a look at a column I wrote last month.)
The “cons” about an IRA rollover are that you — or you and a financial advisor — have to decide how to invest it. In addition, as Storie points out, whether you invest in stock or bonds, your account will be “subject to market volatility,” i.e. fluctuation. You also run the risk of outliving your money if it’s not invested properly.
That’s why you should either find an experienced financial advisor to help you. An alternative would be to use the advisory services that many mutual funds now offer.
However, Storie, a Certified Financial Planning designate, says what to do with your retirement money “might not be an ‘either/or’ choice.” For instance, you might be able to opt for a [partial] distribution from your pension plan, rather than taking the entire amount. This route would give you a (reduced) fixed income from your pension plan and allow you to roll the rest into an IRA where you can invest in a diversified portfolio that has the potential to grow so that your income keeps pace with inflation.
But even if this is an option, Storie says he would still prefer you take the lump sum and, in essence, create your own lifetime “pension” by investing a portion of the money in an immediate fixed annuity [inside your IRA]. In his experience, “you would probably get a better payout than if you left the same amount of money in your pension plan.“ If you choose to do this on your own, he says you could surf the Internet for an insurance company rated “A” or better (the rating refers to the financial stability of the insurer).
The money in your IRA that isn’t committed to the fixed annuity would be invested in a diversified stock portfolio. Depending upon how much money we’re talking about, all or a significant portion of your stock allocation could be invested in a “large-cap value” mutual fund, which pays dividends as well as offers the potential for appreciation. Every major mutual fund family has at least one fund of this type.
Frankly, my recommendation is that you not do this on your own. There are too many potential pitfalls. First of all, if your money is not rolled over properly, you could find yourself owing income tax on the entire amount in a single year and lose the potential for continued tax-deferred growth.
In addition, your lump sum pension payout probably represents the largest amount of money you will invest in your life. If it’s not invested properly, the consequences are severe: you will run out of income before you run out of life!
If you opt to roll over your pension, my recommendation is the same I gave “Carl” last week: ask your family and friends for referrals to financial advisors they use. Interview at least three and choose one to work with.
All the best,
*The maximum account size insured by the FDIC is $100,000.
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The views expressed in this article are those of Ms. Buckner or the individual commentator. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.