An estimated 10,000 boomers retire daily. Some of these retirees who have traditional defined benefit pension plans will face a decision: Start their monthly pension, or take a lump sum distribution and roll it over to an IRA?
It’s a complicated decision, it’s irreversible and each option has strengths and weaknesses. Advisors need to consider quantitative and qualitative factors, and there is no one-size-fits-all solution. Two retirees with apparently similar finances might choose different strategies but nonetheless make the correct choice for their individual situation. Here are some of the considerations you’ll want to address with these clients.
1. Running the numbers
Safety. It’s important to evaluate a plan’s ability to deliver the promised payments. The Pension Benefit Guaranty Corporation (PBGC) backstops failed pension plans but the guarantees have limits. According to the agency’s website: “The 2014 maximum monthly guarantee for a 65-year-old retiree is $4,943.18 which amounts to about $59,320 annually.” The maximums are lower for younger retirees.
John Gugle with Alpha Financial Advisors in Charlotte, N.C., points to the AIG and Bear Stearns experiences as cautionary tales against assuming a pension is always safe. Pensions promised to airline employees are another example. Highly compensated pilots who thought they would be retiring on $90,000 a year instead received the applicable PBGC maximum. Employees “can’t fathom their company for which they’ve worked for so many years ever running into financial difficulty,” he says.
Rates of return. A pension’s internal rate of return is another variable to evaluate. Sandi Weaver of Financial Security Advisors in Prairie Village, Kan., calculates this rate using the client’s standard life expectancy, the available lump sum and the plan’s monthly payment. She then compares that rate to the return expected on her firm’s portfolios, which are roughly 7 percent to 8 percent. If the plan’s rate is significantly lower than that level, she’ll evaluate a rollover. But if the pension’s projected rate of return comes close to matching her firm’s projection, she’ll often suggest the client take the pension.
It’s not just a matter of comparing returns, she stresses — it’s also important to consider retirement income diversification. She cites the three-legged stool in which clients seek a balance of income from pensions, savings and Social Security. Taking a rollover transfers income from the guaranteed pension leg to savings. That move can backfire if the markets experience significant losses, she notes. “If you have half or the majority of your retirement income riding on the stock and bond markets and those take a significant hit, such as we encountered in 2008, you really have to re-strategize and change the lifestyle then, if that suffers a big dent.”
Comparable payouts. Clients sometimes can earn a higher income than the pension benefit by using the lump sum to buy a commercial, single premium immediate annuity (SPIA) with the same payout terms. John Roche in Hartsdale, N.Y., had a case in which the client was retiring from a corporate position and Roche was able to find a better deal with a SPIA. The client then referred a co-worker — a single woman — to Roche, but in her case the corporate pension payment was higher. Roche attributes the variations to the use of mortality tables and other factors, but he continues to compare the payments. “What I’ve learned from all of this over the years is that in every case you really have to run the numbers,” he says. “You can’t take anything for granted.”
Inflation adjustments. Most pensions, especially those in the private sector, lack cost of living adjustments (COLAs). That means the pension’s purchasing power is guaranteed to decline over time and advisors frequently cite that reduction as pensions’ greatest weakness. Consequently, pension COLAs are a very valuable feature, says William Starnes of Mallard Advisors, LLC in Hockessin, Del., because they provide certainty of income plus inflation protection. He believes that a retiree would be “hard-pressed” to bypass the pension and take a lump sum if the pension included a COLA.