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.
2. Beyond the numbers
Optimistic expectations and risk tolerance. Every client is an investment genius during a bull market. They become comfortable with market volatility and convinced they can “beat the pension” and earn a higher return on their retirement funds by taking the lump sum and managing it on their own or with an advisor’s help. Take these same retirees through a market correction, though — like the 37 percent drop in the S&P 500 in 2008 — and a guaranteed pension looks a lot more attractive.
The point is that retirees who want to grab the lump sum based on recent market returns might not truly understand market volatility and their own risk tolerance. One benefit of the bear market was that it helped some investors better understand market risk and the challenge of managing their own retirement funds, according to Ken Robinson with Practical Financial Planning in Cleveland, Ohio. “Since 2008, it’s been a lot easier to dissuade people from gambling their pensions because they’ve seen the market fall by close to 50 percent,” he says.
Income and taxation control. Once the pension starts, so does its associated income tax. The client can’t turn the pension off in high-tax-bracket years and then turn it back on in lower-income years. In contrast, distributions from rollover IRAs can be managed for optimum tax efficiency until required minimum distributions start at age 70 ½.
Spending control. Pensions help keep clients on a reasonable spending plan. If the retiree has a spending problem, however, a lump sum distribution can create an overwhelming temptation to spend. If “you take a million dollar lump sum and you blow through it in five years, it’s gone,” says Starnes. “So, if someone knows themselves and they know if I take this pension I’m going to blow through it, it’s good that they can admit that, but it also means save you from yourself by taking a pension.”
Investment allocation. A pension can act as the no-risk foundation for a retiree’s portfolio. With that predictable income, they can presumably invest their other retirement savings more aggressively knowing that their pension acts like the fixed income portion of a portfolio, says Gugle. “It would allow a conservative investor to take on more risk, or at least we counsel them to consider a more aggressive investment style, if they have a stream of income supporting their lifestyle.”
Estate plans. Pensions have a finite duration — single or joint life — and when the final beneficiary dies, the payments stop. That termination is often a serious drawback for retirees who want to bequest part of the pension’s value to non-spouse beneficiaries, says Paul Winter with Five Seasons Financial Planning, LLC in Salt Lake City, Utah. In those cases, a lump sum distribution rollover allows more flexible estate planning and wealth preservation.
3. Compensation disclosure
Potential conflicts of interest add another dimension to the decision. Advisors generally work on commissions, fees or some combination of the two. While some might factor clients’ pension income into the fees they charge, most don’t earn anything if the client takes the pension. That creates a potential incentive to steer the client toward a rollover so the advisor can earn a commission or management fees on the distributed amounts. The sums involved can be substantial, compounding the potential conflict.
According to the advisors who participated in this article, the simplest way to avoid conflicts is to disclose the compensation that will be earned from following the advisor’s recommendations. Advisors earning asset management fees can provide their fee schedules and estimated annual charges. Advisors working on commission can explain their product recommendations and what they will earn from those sales. It’s basic disclosure, as one source pointed out; it just happens to take place in a retirement distribution context.