In a previous post, we discussed three distribution options available to pensioners. That is, how will you receive the money offered by your pension? While there are multiple ways a pension fund can pay out benefits, we discussed three of the most common options in our previous article:
- In a one-time, lump-sum distribution
- Via monthly payments for the rest of your life (annuitization)
- Via monthly payments for you and your spouse’s life (annuitization with survivor benefit)
However, before making a decision about how to receive your benefit, it’s important to consider:
- life expectancy of the individuals
- solvency of the pension
- liquidity needs
- income needs
- ability or willingness to manage or outsource investing assets
- pension’s rate of investment return
- beneficiary restraints
For today’s post, we’ll discuss one of the considerations above: the solvency of the pension. We’ll look at how selecting the annuitization option subjects the pensioner to pension risk. We’ll also discuss how the alternative route (of taking a lump-sum distribution) subjects the individual to investment risk.
[subtitle3] Investment Risk[/subtitle3]
When you invest your money, you are subject to investment risk. Investment risk is the risk that your investment returns vary over time. Sometimes this variation can include a loss of principal. In plain English: if you invest your money, it is possible that you may lose some of it – at least on a short timeline.
If you do not elect the annuitization routes, you’ll be issued a lump-sum distribution. In order to make that lump-sum distribution as productive as a pension income stream, you’ll have to invest that lump-sum for long-term growth. This means either investing the money yourself, or hiring an investment manager to do so for you.
[subtitle3] Who gets Investment Risk?[/subtitle3]
Consider the risk of each pension pay-out choice:
- With the annuitization option, investment risk lies with the pension fund. This is pension risk.
The pension bears the risk that a poor investment return will leave the pension short of funds to pay pensioners. (This is the pension’s problem – and hopefully not the problem of the recipient of the pension payouts: the annuitant.) In a scenario of poor investment returns, the pension fund can offset the poor return with larger contributions (cash inflows). That is, the pension fund will pay pensioners with cash not from the pension’s investment pool, but with new money coming into the pension fund.
The retiree does not have this option: supplementing a poor investment return by increasing contributions to the investment pool. (The exception is if the retiree goes back to work). When investing a lump-sum distribution, your particular investment return dictates your income. For example, if the market performs poorly in a particular year, you may see a smaller income than the previous year. In short, when taking a lump distribution, the investment risk is borne by the individual investor.
[subtitle3] Trading Investment Risk for Pension Risk[/subtitle3]
With the annuitization option, you are guaranteed (by the pension) certain income for life. However, while you may not be subject to investment risk, you will be subject to pension risk: risk that the pension is underfunded and/or issues a distress termination.
In a distress termination, pension benefits are paid out on the basis of funds available. If the pension is underfunded, you may receive less benefits than those originally quoted by the pension fund. Though you may still be receiving monthly income for life, the amount of that monthly income may be much less than anticipated. This will ultimately impact your budget, and quality of life in retirement.
One factor that can help you determine how at-risk your pension fund is the pension’s under-funding. This information can be sourced from the pension directly, usually in an annual report. Sometimes, this information may even be available on their website. Consider an example, as of 2014:
CalSTRS is underfunded by $73 billion.
Remember: when opting for annuitization, you are trading investment risk for pension risk.
[subtitle3] Mitigated Pension Risk[/subtitle3]
Pension Risk is somewhat mitigated by the Pension Guaranty Insurance Corporation (PGIC), the government body that insures pensions. However, when underfunded pensions are taken over by the PGIC, you may see a reduction in benefit payments. This is because though the PGIC does insure pension benefits, benefits are insured up to a limit. Today’s limits of PGIC’s insurance covers up to $59,320 annually for 2014, for an individual age 65.
These limits provide a floor through which pension benefits cannot fall (though it can be discouraging to see just how much one’s benefit can fall before reaching the floor). Consider that it is not uncommon for retired grade school instructors to receive pensions providing annual income north of $90,000. Assuming a pension default and successive take over by the PGIC, the pensioner is looking at a $30,000+ cut in annual living expenses (gross of taxes). The consequence is much greater for pensioners receiving larger income streams; in one anecdotal example, an airline pilot ended up receiving 30 cents on the dollar when his pension fund collapsed.
[subtitle3] Making a Choice[/subtitle3]
When considering which pension distribution option to choose, consider the risks:
- How underfunded is the pension?
If you’re going to receive benefit payments from a fully-funded pension, you’re facing less risk than if your pension was coming from CalSTRS, as an example – all else being equal.
- How much do you stand to lose in a distress termination?
If you’re looking at receiving a very large income stream from your pension, know that only a small portion of that income stream is insured. All else being equal, those pensioners receiving large benefits stand to lose a lot more than those receiving more modest pension benefits (because pension benefits are insured up to a certain limit).
∙ ∙ ∙
Pensioners commonly face the option of taking a lump-sum distribution or choosing annuitization. This can occur at retirement, or in the event that the individual employee is switching employers. If you’re unsure which pension distribution option is right for you, work with a fee-only financial planner to determine the best solution for your particular situation.
California State Teachers’ Retirement System. (2014). Plan Funding – CalSTRS.com. Retrieved from CalSTRS.com – How will you spend your future?: http://www.calstrs.com/plan-funding
Pension Benefit Guaranty Corporation. (2014). Basic Benefits Guaranteed by the Pension Benefit Guaranty Corp. Retrieved from Pension Benefit Guaranty Corp – PBGC Protects America’s Pensions: http://www.pbgc.gov/wr/benefits/guaranteed-benefits.html