Lump sum pensions: a bad deal for most

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Mark Miller

Traditional pensions are an endangered species in the private sector. But if you’re lucky enough to have one, you may face a choice at retirement: Take the money as a lump sum, or as a monthly lifetime annuity-style payment?

About one-third of private sector workers who have traditional defined benefit pensions are in plans that offer this choice. And most of them opt for a lump sum, partly because it can sound like so much money, and partly because of all the bad news we’ve seen in recent years about big pension plans that have gone belly up.

But lump sums are usually a bad deal. Most people would come out far ahead over the course of retirement with an annuity. And lump sums are getting to be even less attractive due to recent pension reform legislation that mandates changes in the way lump sum payments are calculated.

How annuities differ

Pension plan sponsors calculate lump sums using longevity and interest-rate statistics, aiming to match the amount you’d need to invest to match the annuity-style checks you’d receive from your normal retirement age. In that sense, the choice between lump sum and annuity should be neutral, producing the same result over time.

But that’s not the case. While the outcome depends on a number of factors — how you invest the money, whether you’re a male or female, and whether you’re married — most people will come out ahead with an annuitized pension. Here’s why:

Lifetime income. Say a retiree is entitled to a monthly pension of $1,000 at age 65, payable for life. If she wants to convert that to a lump sum, the actuarial formulas would have her walk out of her employer’s door with about $140,000.

Of course, that sounds like a lot more money than $1,000, and that’s why so many retirees take the lump sum if they’re offered a choice. But if our retiree is married, she could elect a joint-and-survivor benefit with a slightly lower monthly payment around $850. That payment would come every month of their lives — good times or bad — until both of them have passed away.

Human behavior and market risk. Now, let’s consider the lump sum. For starters, our retiree must invest it to generate lifetime retirement income. In addition, she runs the risk of withdrawing too much, market setbacks, or living much longer than average — creating the need to stretch her nest egg much further.

Safety. Some retirees worry that their pensions won’t be there for them if their employer experiences financial catastrophe. Indeed, defined benefit pensions have gotten a good deal of bad press as a result of high-profile failures of underfunded plans at companies such as United Airlines and U.S. Airways.

But pension safety is improving due to passage of the Pension Protection Act of 2006 (PPA), which includes important reforms that require all plans to get to 100 percent funding over a period of years.

It’s also important to know that most private plans are insured by the Pension Benefit Guarantee Corporation (PBGC), a federally-sponsored agency funded through premiums paid by plan sponsors. When a plan fails, the PBGC assumes responsibility for making benefit payments up to an established maximum amount. While it’s possible to lose some income if your benefits exceed the PBGC’s cap, most beneficiaries come out whole.

Changing formulas. When the PPA was passed, plan sponsors lobbied successfully for a change in the benchmark interest rate used to calculate lump sums. They argued that lump sum payments were being inflated artificially by ultra-low 30-year Treasury rates.

So the PPA replaced the Treasury rate with a higher composite corporate bond rate that will be phased in fully in 2012. The corporate rate is a little over 100 basis points higher than the Treasury rate.

“All other things being equal, it means a lower lump sum,” said Alan Glickstein, a senior consultant and pensions expert at Towers Watson. “For someone close to retirement age, it works out roughly to a 10 percent change in value for every one percentage difference in interest rates.”

Women get an especially bad deal. The actuarial tables governing lump sum calculations are unisex, but women outlive men by about four years on average. That means female workers who take lump sums get shortchanged.

Incentives favor annuities. Many employers offer older workers pension incentives to retiree early, but they aren’t required by law to include those sweeteners if you take a lump sum.

“Let’s say you’d get a $1,000 pension at age 65,” said Glickstein. “If you took early retirement at 55, it might be worth only $400 a month. But the plan sponsor might offer $600 to encourage you to retire — that’s a fairly common design.

“But that extra amount might not be included in the lump sum calculation. So, you could be forfeiting that extra subsidy — so be sure to ask your employer how it’s calculated.”

A lump sum can make sense in some situations, Glickstein said. “The key factors are how long you’re likely to live, and what you plan to do with the money.

“For example, say you’re married and your spouse receives a monthly pension. You might want to take the lump sum to invest in a business or travel.

“But if this pension is going to be your primary source of income in retirement alongside Social Security, consider taking the annuity.”

Mark Miller is the author of “The Hard Times Guide to Retirement Security.” He publishes http://retirementrevised.com, recently named the best retirement planning site on the web by Money Magazine. Contact him with questions and comments at mark@retirementrevised.com.