Planning Reflection | April 29, 2022
For most of the 20th century, the promise of a pension was an exciting benefit for employees of private and public employers alike. While still common for government workers, pension plans are increasingly rare among private employers.1 Over the last 40 years, many employers have shifted to offering 401(k) or 403(b) plans instead of pensions. By 2020 only 15% of private workers still had access to a defined benefit plan.2 This is a reflection of employers’ decisions to shift the risk of investing from the company, which is responsible for the pension fund’s investment performance, to the employee, who is responsible for the performance of their 401(k).
For those employees who still have access to a pension plan, they must decide at retirement whether they want to manage their own pension assets and maximize their flexibility, or whether they want to delegate that to their employer in order to maximize certainty.
The Basic Choices
In some ways, pensions represent a straightforward agreement. The longer you work for your employer, the larger the benefit you’ll get when you retire. You don’t need to decide how much to contribute, nor how to invest the funds along the way. You also know the pension amount in advance so it’s easy to incorporate it into retirement planning. As a pension participant, you can request information from your employer about the specific benefit options to understand the progress you’re making toward retirement, as well as the landscape of available choices.
A pension’s benefit is defined in terms of a “single life annuity,” an income stream that will be paid out to you over your lifetime, and that will stop when you die. If you want to provide benefits to a spouse or other survivor, the monthly payment will be reduced based on your joint life expectancy. The payment will also be reduced if you want to guarantee heirs a stream of income over a fixed period such as 10 or 15 years in the event that you die soon after the pension payments begin. These choices are mathematically equivalent, but may have very different values to you depending on your personal situation.
While the lifetime payment options can be complex, most plans also offer a lump sum payment that is equal to the present value of your single life annuity, and that can be transferred into a tax-deferred IRA. From there, you can decide how to invest the assets, and what sort of income stream you want to take. Some people choose to take nothing for a period of time or to take a larger single sum for gifting to family or a large expense such as home remodeling.
Evaluating Your Plan
If you choose a lifetime stream of income, the presence of a cost-of-living adjustment (“COLA”) will be essential to its actual value, because the COLA preserves purchasing power over time. Inflation is particularly salient right now, but even in a lower inflationary environment, price increases add up over time. For perspective, 20 years of 3.5% inflation will lead to a doubling of prices on average. In that circumstance, after two decades a $5,000 monthly pension would only buy $2,500 worth of goods and services. In our experience, governmental pensions like CalPERS, CalSTRS, and the UC system have some form of COLA, while private pensions do not. Even if your pension does have a COLA, it may not fully protect you against inflation.
Another factor to consider is the financial strength of the employer. The guarantee of the income stream – the most important benefit of a pension – is only as strong as the organization responsible for paying it. Pension plan sponsors are required to maintain an appropriate level of funding in the plan to ensure they will be able to cover current and future benefit payments.3 Most private employers are required to pay for pension insurance through the Pension Benefit Guaranty Corporation (PBGC), a federally chartered corporation tasked with protecting private pensioners’ benefits. If an insured pension plan fails, the PBGC will step in and ensure that benefits continue to be paid to participants, although they will likely face a reduction in payments.
Balancing the Alternatives
Comparative analysis of your plan’s specific details can weed out less than ideal options, but having the numbers can only take you so far. The remaining options may be numerically similar, but often there are distinct emotional tradeoffs among the alternatives.
A pension offers you the certainty of a guaranteed level of income, no matter how long you live. This, in turn, can provide a significant feeling of security – it mitigates or even eliminates the concern that you might outlast your savings. This certainty comes at the cost of flexibility because you don’t have immediate access to the full value of your pension. If you’re married, you face another version of this same tradeoff: choosing a higher survivor benefit means starting with a lower benefit for the two of you from the beginning. You get the certainty and security that if you die first your spouse will have some minimum level of resources, at the cost of a reduced monthly benefit.
A lump-sum payout offers opportunities not available if you have a pension. You have the certainty of the bird in the hand – no matter when you and your spouse pass away, your heirs will receive the full value of your pension – and you have the flexibility to access the funds as you see fit. The tradeoff is that you’re taking on the risk and responsibility of producing sufficient investment return to preserve your ability to spend as needed over your lifetime.
Choices in Context
Regardless of the form it takes, a pension represents a resource that needs to be integrated with the rest of your financial landscape. That includes your other resources, your spouse’s situation and needs, the needs of any adult children, your interest in funding gifts to grandchildren’s education or charitable organizations, and many other factors. Although the wide array of choices can seem overwhelming, an effective balance of quantitative and emotional considerations can lead you to a pension election that is personalized to your life and goals.
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About Sam Wood-Bednarz, CFP®
Sam Wood-Bednarz is a Partner, Senior Advisor, and Director of Financial Planning. He provides clients with a sense of confidence and security in their financial lives.
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