Not so many years ago, financial advisors viewed retirement planning as a three-legged stool. The first leg was a pension, the second Social Security and the third a retiree's savings. Over time pensions have fallen by the wayside, and aside from government workers and teachers, an active pension plan is rare.
Nevertheless, many retirees have legacy pensions and as they retire, they are faced with the choice of drawing those pensions or taking the accrued value in the pension as a lump sum. When clients ask us whether they should keep a pension or cash it in, one of the first things we point out is that the pension is a stable stream of income in retirement. Furthermore, depending upon the option the retiree uses in taking the pension, it is a stream of income that is guaranteed for life.
The pension provider takes the risk of both sub-par market returns and the possibility that the retiree will live longer than expected. While this can be helpful, there are several specific points to consider when making the decision:
Implied Return on Pension
We calculate the return on the pension by assuming the lump-sum the client could take was invested and the investment generated a stream of income. The longer the pension pays out (the longer the retiree lives), the higher the implied return. We compare that return to the long-term return one would expect from investing in a diversified portfolio.
This is heavily influenced by the amount of the lump-sum and varies greatly by person.
Impact on Retirement Plan
The goal of a retirement plan is to fully fund the retiree’s spending needs through the balance of his or her life. If the plan includes an investment portfolio, the portfolio is usually a key source of income. But it’s an uncertain source of income since returns will vary.
The pension, on the other hand, is a steady stream of income which won’t vary, and usually won’t even adjust for inflation. For some plans, this is okay. The steadiness of the return is more important than the fact that the income doesn’t grow. In other instances, growth is needed. By modeling the pension in a stress-tested plan, we can get a sense of whether maintaining the pension or cashing out is a better choice for the client.
Choosing to take a pension over a lump-sum distribution is an irrevocable option. If spending is variable or there is a good bit of uncertainty around spending needs, we counsel caution. Caution may not mean taking a lump sum, it could simply require delaying the pension decision. The more complete the client’s information, the easier it is to decide.
Health of Pension and Trustee
Pensions can be underfunded and trustees can and have gone bankrupt, leading to the reduction or even outright elimination of pension payments for plan participants. It doesn’t happen often, and when it does, the Pension Benefit Guarantee Corporation (PBGC) may assume responsibility for payments. However, in recent years the PBGC has been chronically underfunded and it’s difficult to predict where things may stand in 10 years.
In assessing whether to take the lump-sum or to accept the pension, make sure you understand how well funded the plan is and the position of the trustee.
Even a small pension is an advantage in retirement that most no longer have. If you do and have been given the option to keep a pension or cash it in, working through the issues outlined above can help you make the optimal financial decision.
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