By Laura Bruce • Bankrate.com
Across the country, many companies are struggling with underfunded defined benefit pension plans.
Some plans, such as Northwest Airlines', are underfunded by billions of dollars. Officials at the Pension Benefit Guarantee Corporation, or PBGC, a federal corporation that guarantees the payment of basic pension benefits, say 1,108 American corporate pension plans are underfunded by a total of $354 billion. But, the true amount is worse than that; companies aren't required to report underfunding unless the deficit is more than $50 million.
As pension plans become vulnerable because of underfunding or corporate bankruptcies, workers must decide whether to take their payout in a lump sum or agree to an annuity and, perhaps, risk learning later that they might receive a fraction of the benefit they had expected.
"The pros of taking a lump sum outweigh the cons much more today than five or 10 years ago," says Eric Hutchinson, certified financial planner and chairman of Hutchinson/Ifrah Financial Services in Little Rock, Ark.
"In today's environment, it would be hard to advise taking the annuity because of the underlying risk involved of whether they'd actually see those payments. Or, if PBGC takes over, they get substantially reduced payments than they expected."
PBGC annually sets the maximum benefit for plans that it takes over. For instance, plans terminating in 2005 will pay a maximum benefit of $45,614 per year to workers who retire at age 65. That can be a major blow to airline pilots or skilled tradesmen expecting a far-greater pension to see them through retirement.
Another fly in the ointment in all of this is that PBGC has financial problems of its own. PBGC gets its funding from, among other things, insurance premiums paid by companies with defined benefit pension plans. The organization says it ended 2004 with a deficit of more than $23 billion. PBGC is a government corporation, but its obligations are not backed by the "full faith and credit of the U.S. government."
Not all corporate-pension plans allow participants the choice of taking a lump-sum payout, and usually workers can only access their pension after leaving a company. There's an Internal Revenue Service penalty if you take a distribution before age 59½, but you can avoid that if you roll your pension into an IRA.
To a large extent, the lump sum is based on your age at retirement and the interest rate the pension plan uses, which is usually the 30-year Treasury.
"The hard part about a lump sum is the low interest-rate environment requires the pension to give you a bigger lump sum than they would otherwise, because with interest rates so low you need a bigger sum of pension money to create the pension you're supposed to receive," says Chris Cooper, CFP and founder of Chris Cooper & Company, in Toledo, Ohio.
"A lot of people would like to retire now and take a lump sum, because they'd get as big a sum now as they'd ever get because of interest rates being so low."
But a change could be in store if Congress passes legislation aimed at reforming funding rules for defined benefit plans. A Treasury Department proposal creates a corporate bond yield curve for determining how much money companies must pay into their plan and also for determining lump-sum payments. The yield curve would be based on high-grade corporate bonds.
Norman Stein, a law professor at the University of Alabama, says the effect on lump-sum payouts, currently determined using the 30-year Treasury, could be significant.
"The new legislation will reduce the size of the lump sum. Now it's calculated using an interest rate no less favorable than the 30-year Treasury, which is low. Using a modified yield curve based on corporate bonds would raise the interest rate and could take a big bite out of the lump sum.
"If there's a 2-point difference and the rate is 15 percent vs. 17 percent it won't make that much of a difference. But if the Treasury is 4.5 percent and the corporate is 6.5 percent, that would make a really big difference, plus they're using a yield curve which means interest rates will generally be higher and more negative, especially for people who don't receive payouts for a while."
David Certner, director of federal affairs for AARP, points out how detrimental that calculation might be for workers 30 years from retirement who opt for a lump sum at that time. His example is based on his contention that corporate rates usually are roughly 75 basis points above Treasury rates
"Depending on how many years you are from retirement, it's basically a 75 basis point reduction each year in that calculation and that can mean a 10 percent to 40 percent reduction (in the lump sum) depending on your age. If you're 30, you're talking about 30 years of discounting roughly 75 basis points a year. For employers, of course, that leaves more money in the plan. We should use a conservative rate. We're shifting the risk on to the individual."
Even if legislation is enacted that reduces lump-sum payouts, Hutchinson advises opting for the one-time payout.
"We recommend taking the lump sum, period. Having control of the money and being able to access it and pass it on to heirs -- the control factor is significant and totally lost in the annuity environment."
Annuity payments are made during the lifetime of the employee. There are options to provide a benefit for a surviving spouse, but that reduces the employee's monthly check.
Employees who decide to go the lump-sum route should consider getting professional advice on how to manage the money, says Cooper.
"There are tax matters to think about, and you have to determine how to invest the money. There's risk management -- what risks do you have? If you have a lump sum and your spouse goes into a nursing home, that money could be an asset at risk. Maybe you need long-term care insurance. Maybe you need increased personal liability insurance because you have more money that you used to. Update your will, and give someone power of attorney. Make sure your family can access the money and use it to take care of you."
There is also a possibility that pension-reform legislation will restrict access to lump-sum distributions if the pension plan is underfunded below a certain level.
Whether you plan to take a lump sum or an annuity, keep an eye on your company's pension plan. At a Senate committee hearing in June 2005 on pension reform, PBGC Executive Director Bradley Belt testified that United Airlines had four pension plans and that "from 2000 onward, when the true funded status of each of the company's pension plans was deteriorating and the financial health of the company was becoming more precarious, the company put little if any cash into the plans, rarely made a deficit reduction contribution, and never provided any notices of underfunding to participants."
Pension-reform legislation may provide for better disclosure when companies are facing financial problems that are affecting pension plans. But employees should take a proactive stance and inquire about the health of their company's pension plan.
Across the country, many companies are struggling with underfunded defined benefit pension plans.
Some plans, such as Northwest Airlines', are underfunded by billions of dollars. Officials at the Pension Benefit Guarantee Corporation, or PBGC, a federal corporation that guarantees the payment of basic pension benefits, say 1,108 American corporate pension plans are underfunded by a total of $354 billion. But, the true amount is worse than that; companies aren't required to report underfunding unless the deficit is more than $50 million.
As pension plans become vulnerable because of underfunding or corporate bankruptcies, workers must decide whether to take their payout in a lump sum or agree to an annuity and, perhaps, risk learning later that they might receive a fraction of the benefit they had expected.
"The pros of taking a lump sum outweigh the cons much more today than five or 10 years ago," says Eric Hutchinson, certified financial planner and chairman of Hutchinson/Ifrah Financial Services in Little Rock, Ark.
"In today's environment, it would be hard to advise taking the annuity because of the underlying risk involved of whether they'd actually see those payments. Or, if PBGC takes over, they get substantially reduced payments than they expected."
PBGC annually sets the maximum benefit for plans that it takes over. For instance, plans terminating in 2005 will pay a maximum benefit of $45,614 per year to workers who retire at age 65. That can be a major blow to airline pilots or skilled tradesmen expecting a far-greater pension to see them through retirement.
Another fly in the ointment in all of this is that PBGC has financial problems of its own. PBGC gets its funding from, among other things, insurance premiums paid by companies with defined benefit pension plans. The organization says it ended 2004 with a deficit of more than $23 billion. PBGC is a government corporation, but its obligations are not backed by the "full faith and credit of the U.S. government."
Not all corporate-pension plans allow participants the choice of taking a lump-sum payout, and usually workers can only access their pension after leaving a company. There's an Internal Revenue Service penalty if you take a distribution before age 59½, but you can avoid that if you roll your pension into an IRA.
To a large extent, the lump sum is based on your age at retirement and the interest rate the pension plan uses, which is usually the 30-year Treasury.
"The hard part about a lump sum is the low interest-rate environment requires the pension to give you a bigger lump sum than they would otherwise, because with interest rates so low you need a bigger sum of pension money to create the pension you're supposed to receive," says Chris Cooper, CFP and founder of Chris Cooper & Company, in Toledo, Ohio.
"A lot of people would like to retire now and take a lump sum, because they'd get as big a sum now as they'd ever get because of interest rates being so low."
But a change could be in store if Congress passes legislation aimed at reforming funding rules for defined benefit plans. A Treasury Department proposal creates a corporate bond yield curve for determining how much money companies must pay into their plan and also for determining lump-sum payments. The yield curve would be based on high-grade corporate bonds.
Norman Stein, a law professor at the University of Alabama, says the effect on lump-sum payouts, currently determined using the 30-year Treasury, could be significant.
"The new legislation will reduce the size of the lump sum. Now it's calculated using an interest rate no less favorable than the 30-year Treasury, which is low. Using a modified yield curve based on corporate bonds would raise the interest rate and could take a big bite out of the lump sum.
"If there's a 2-point difference and the rate is 15 percent vs. 17 percent it won't make that much of a difference. But if the Treasury is 4.5 percent and the corporate is 6.5 percent, that would make a really big difference, plus they're using a yield curve which means interest rates will generally be higher and more negative, especially for people who don't receive payouts for a while."
David Certner, director of federal affairs for AARP, points out how detrimental that calculation might be for workers 30 years from retirement who opt for a lump sum at that time. His example is based on his contention that corporate rates usually are roughly 75 basis points above Treasury rates
"Depending on how many years you are from retirement, it's basically a 75 basis point reduction each year in that calculation and that can mean a 10 percent to 40 percent reduction (in the lump sum) depending on your age. If you're 30, you're talking about 30 years of discounting roughly 75 basis points a year. For employers, of course, that leaves more money in the plan. We should use a conservative rate. We're shifting the risk on to the individual."
Even if legislation is enacted that reduces lump-sum payouts, Hutchinson advises opting for the one-time payout.
"We recommend taking the lump sum, period. Having control of the money and being able to access it and pass it on to heirs -- the control factor is significant and totally lost in the annuity environment."
Annuity payments are made during the lifetime of the employee. There are options to provide a benefit for a surviving spouse, but that reduces the employee's monthly check.
Employees who decide to go the lump-sum route should consider getting professional advice on how to manage the money, says Cooper.
"There are tax matters to think about, and you have to determine how to invest the money. There's risk management -- what risks do you have? If you have a lump sum and your spouse goes into a nursing home, that money could be an asset at risk. Maybe you need long-term care insurance. Maybe you need increased personal liability insurance because you have more money that you used to. Update your will, and give someone power of attorney. Make sure your family can access the money and use it to take care of you."
There is also a possibility that pension-reform legislation will restrict access to lump-sum distributions if the pension plan is underfunded below a certain level.
Whether you plan to take a lump sum or an annuity, keep an eye on your company's pension plan. At a Senate committee hearing in June 2005 on pension reform, PBGC Executive Director Bradley Belt testified that United Airlines had four pension plans and that "from 2000 onward, when the true funded status of each of the company's pension plans was deteriorating and the financial health of the company was becoming more precarious, the company put little if any cash into the plans, rarely made a deficit reduction contribution, and never provided any notices of underfunding to participants."
Pension-reform legislation may provide for better disclosure when companies are facing financial problems that are affecting pension plans. But employees should take a proactive stance and inquire about the health of their company's pension plan.
