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Should You Take A Lump-Sum Pension Offer?

There are pros and cons to taking a pension lump sum. Know your priorities!

 

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by Paul Kindzia in Personal Finance
October 27, 2017

A Growing Pension Crisis Looms

Our nation faces a mounting and significant future pension crisis.  When the global economic meltdown occurred in 2008/2009 and the central banks around the world manipulated interest rates down to zero (or even negative interest rates), they put pensions funds, endowments funds, annuity companies, and insurance companies on a death march to insolvency.

Many of these funds run actuarial type models that forecast future outflows based on the number of plan participants, age, and mortality estimates of the demographic group.  They then use estimated rates of return that have been applicable over the past few decades in global financial markets.

That’s where the main problems begin.  Most pension funds use a future rate of return (total from all asset classes) of 7.5% – 8.0%.  They arrive at this estimate in a simplified fashion.  Historically a diversified bond portfolio will yield 6% (also allowing for smooth, safe and predictable cash inflows from the interest income off of the bonds).  They then estimate a 10% return on equity or risk type assets (such as stocks, real estate, commodities or private equity).  If they put 50% of the funds in bonds earning 6% and 50% of the funds in risk assets earning 10%, then they should average 8% over time and their numbers will work.

Since interest rates have been kept lower for what is quickly approaching a decade, these funds have not been generating anywhere close to 6% of their bond investments (which is 50% of their holdings).  Compound this problem with a growing likelihood that interest rates will rise in future years (reverting back to the mean).  When interest rates rise, the price of bonds decreases (leading to capital losses on a bond portfolio).  It is entirely possible that pension funds will LOSE money over the next decade on 50% of their portfolios (from the bonds) and thus never even come close to generating the 6% that was used in the estimates.

With stock prices/valuations at extreme levels (certainly in the danger zone for large capital losses over the next few years), the other 50% of the portfolio also is in danger of losing capital.  The 10% estimates used on the other half of the portfolio are more like a pipedream that is very unlikely to happen.

With each passing year, the gap widens.  Companies and governments are lacking the cash to make the required contributions to keep the plans fully funded.  Thus, they are generating what is called, “unfunded liabilities.”  These unfunded liabilities continue to mount and the rate of unfunded liabilities has actually reached a tipping point with many pension plans around the world.  The math has shown that the plans for all intents and purposes are going to be insolvent.  They will never be able to pay the promises made when times were better (or when politicians made promises to get elected that were bogus to begin with.)

Needless to say, we have a looming pension crisis that has been well documented for anyone willing to pay attention.  If you would like to learn more about the upcoming pension crisis, just Google “Pension Crisis” and you will have plenty to keep you busy (and awake at night if you are a financial planner.)

Some assumptions that you may want to consider:

  • When stock valuations are at levels where they are today (extremely high as we are at the tail end of 2017 when this article was written), then the future 10-year rate of return is very low (all future returns are already baked into the cake).  To make higher returns would require even more extreme levels of valuations in the short to medium term future.  Thus, you should be more concerned with equity rates of returns over the next 3, 5 or 10 years (or at least until we get a very significant correction).  You can actually return to more normal valuations if the prices of equities just went sideways for a decade and the economy slowly recovered.  It’s not probable as this has never played out in the past with extreme valuations, but it is possible.
  • What you don’t know is what interest rates will be when you are 65, 75, or 85 years of age.  That’s the big question.  Because if you knew what interest rates were going to be on risk-free assets (high-quality sovereign debt), then you would possibly be able to have your cake and eat it too because you would generate adequate earnings AND be able to dip into principal if you wanted to by taking the lump-sum and investing/managing it yourself.  (Note, you cannot dip into the principal once you start to draw a pension.  You are restricted to equal periodic payments that are locked in).

The Real Benefits Of A Pension

  • You don’t have to know what stocks, bonds, commercial real estate, interest rates, inflation, or the global economy is going to do in the future.  You stop worrying about that kind of uncertainty when you elect to take the pension distributions for life.  Rather, you just put your faith in the company’s ability (or the pension guarantee insurance fund) to pay you what is owed to you.  That is a wonderful thing to not have to worry about all of the economic uncertainty and stock market noise in your golden years.
  • If you believe you are going to live a long time (high life expectancy), the predictable lifelong income is a wonderful asset to own through a pension plan.  That’s why you should run a life-expectancy estimate prior to making significant lump-sum decisions and use those estimates in your analysis.  Think of it this way, if you are in poor health, have bad genetics, or abused your body over your working years and are likely to pass away in your late 60’s or 70’s, then a lifetime stream of payments isn’t a good deal for you or your household.  The lump-sum is more attractive as you would be able to tap into that principle in the early years of your retirement and use for quality of life items or healthcare expenses.  Knowing your life expectancy estimates allows you to make very intelligent pension decisions.
  • If you think of the “old school” model of planning, it’s wonderful if households have fully funded retirements coming from three sources;
    • Social Security Income (usually 1/3 of retirement requirements).  You should pull your Social Security Benefits each year and review for planning purposes.
    • Pension Income (usually about 1/3 of retirement requirements).
    • Personal savings and investments (the last 1/3 of retirement requirements).
    • These are the “three legs” of the retirement stool that was valid for past retirees.
    • The issue now is that Social Security is in jeopardy (underfunded and unlikely to pay out what was promised to all participants), pension funds are facing an underfunded crisis and unlikely to pay out anywhere close to what was promised, and households are generally undersaved on the personal savings and investments side of things.  Sounds like fun times ahead, right?  So you don’t want to be like most people with complete uncertainty as to your future.  Plan ahead!

If you value “the security and comfort of having a lifelong income stream” AND you trust the ability of the pension fund to pay you what is owed, then you should take the pension lifetime payout option and “stick it to the company” by living until 115 years old!  You should focus on being as healthy and as active as possible and be the person who gets the most return from the pension by living a very extended period of time.  That’s how you really win the pension game.  You live a really long time while healthy and active.

The downsides of a pension plan

  • If your life expectancy is low (you have pre-existing conditions, poor health, bad genetics), then you may feel more in control of your assets by taking the lump sum and controlling it yourself through an IRA rollover.  If you have a low life expectancy you are helping the pension fund because the payout to you personally is statistically very low.  You lose by dying early without getting the benefit of a lifetime payment asset.
  • You can’t tap into a pension once started for lump sums for whatever reasons.  You may want larger sums of distributions for home projects, vacations, emergencies, medical needs, etc.  If you need large sums of money, you need to pull it from other sources because once the pension payments begin, you are locked into those monthly payments until you pass away.
  • You can’t leave the pension asset to beneficiaries (children, grandchildren, charities).  Rolling over a pension via a lump sum into a qualified IRA allows you full control over the funds including naming a beneficiary.  Whatever funds are left after you are deceased can be passed down to a beneficiary(s) of your choice.
  • A SIGNIFICANT downside of a pension plan in current conditions is the risk that the pension plan becomes so underfunded that it will never pay what is owed.  This is a very common and growing problem.  There are countless examples of pension benefits being cut to recipients even AFTER the participant has retired (see auto industry employees after the bankruptcies of major auto manufacturers).  Most pension plans are underfunded and the liabilities continue to grow.  Just because a company or municipality has promised you a pension benefit does NOT mean that the funds are there to make the promised payment to you.  You can file lawsuits all day long and argue why you are wronged financially.  But if the money doesn’t exist, you will have a major problem on your hands as you find yourself without benefits you were counting on.

Areas To Focus On When Making A Lump-Sum Offer Decision

Many people are being offered a “one-time pension lump-sum distribution”.  You have to think through why you are being offered this opportunity to take the lump sum.  Do you really believe that your former employer is in a generous and charitable mood and has plenty of extra money to throw around?

The reason that you are even being offered a payout is that your former employer has a major problem on their hands.  Their pension plan is underfunded, has growing unfunded pension liabilities and is in jeopardy of breaking contractual obligations that will greatly impact future earnings and cash flows of the entity.  One way that they could cut off the bleeding is to make plan participants “go-away.”  They do that by making you a lump sum offer.

The fact that you are receiving a lump-sum offer is an indication that the company feels a problem is growing that impacts the entity (and ultimately the compensation of the management team).  Every dollar that has to be re-routed to shore up pension deficits are dollars that can’t be used to grow the business or pay executive compensation.

Concentrate on keeping your analysis as simple as possible focusing on the following items;

  • Your estimated life expectancy
  • The ability of the pension plan to meet its obligations (research the unfunded liabilities and future unfunded liabilities).  Is the corporation a dying organization?  All companies have life cycles.  There are plenty of companies that at one point in time were strong industry leaders that eventually went bankrupt (Eastman Kodak, Xerox, General Motors, Lucent Technologies, the list is quite long).  When companies die, that puts your pension in jeopardy.
  • Do you want the ability to access lump-sums in retirement for special needs?
  • Do you want to leave assets to beneficiaries (leave them what is remaining if you pass away early)?

Finally, one piece of advice.  Some people are taking comfort in believing that the Pension Benefit Guarantee Corporation will be there to save them if their company pension plan defaults.  This is a topic for an entirely separate article.  Don’t trust that the funds are there to protect you in the case of default.  There are so many plans that are unfunded, there is no possible way that the PBGC can cover all of the eventual shortfalls.

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