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Why Wouldn’t you Want a Guaranteed Pension?

Why Wouldn’t you Want a Guaranteed Pension?

Client Question:  Why wouldn’t you want a guaranteed pension?

Advisor Answer:  There are two primary answers to this question, in my opinion.  The first is that many pensions are NOT actually guaranteed based on how most people I know interpret the word guaranteed (i.e. not merely a promise, but something that is without a doubt going to happen).  In fact, many pension plans are clear in admitting that benefits are subject to change.  The second answer is that one may be able to build a more valuable asset through a defined contribution plan (e.g. 401(k) plan) than a defined benefit plan (e.g. pension).

Why do you say pension plans are not actually guaranteed?

Many people believe their contributions to a pension plan are similar to that of a 401(k) plan in the sense that their contributions are directed into a personal investment account (that a professional manages) where assets grow over time.  Common (albeit misdirected) thinking then goes that the guaranteed projected pension benefit is a function of the accumulated value of the aforementioned personal investment account.  If you have ever read the fine-print of many pension plans, you have probably realized that this is not how many pension benefits are calculated.  In fact, many projected pension benefits are calculated by taking someone’s “Final Average Salary” and multiplying it by a “multiplier.”  The Final Average Salary is often calculated by averaging an employee’s highest three years of income and the multiplier is based on how many years someone has worked.  If it seems like the contributions made to a pension should have more of an impact on the pension benefit calculation then you are thinking clearly!

Let’s take things a step further.  Not only does each individual employee not have a personal investment account into which pension contributions are directed, but part of their pension contributions are actually being used to pay current retirees.  So, you are giving your money to the company and the company is handing that money to someone else to spend.  What could go wrong here?  One obvious thing that could go wrong is that the number of employees contributing into the pension plan could decrease for any variety of reasons, which would unexpectedly limit the funding of the pension benefits for existing retirees.  For example, there are substantially less employees for Kodak now than there were 30 years ago given the technological advances and competition in camera industry.  And guess what, Kodak defaulted on it’s “guaranteed” pension benefit to retirees!

While much of the money that employees contribute to a pension goes straight out the door to pay someone else, some of it is often invested.  This brings us to another potential issue.  Perhaps the investments (e.g. stocks and bonds) that the pension funds are invested in do not perform well enough to account for the calculated pension benefit.  This means that the pot of money to fund pension benefits could be shrinking while pension “guarantees” are growing.

How do you compare a pension benefit to a 401(k) plan?

Before getting into the “Nitty Gritty” of comparing these two financial assets, it is important to point out two fundamental differences between them.  The first is that you can withdraw as much money as you want (to the extent that you still have money in the account!) from your 401(k) plan whereas you are limited to your monthly benefit through a pension.  If you are retired and have a $500,000 401(k) plan, you can withdraw up to $500,000 at any time.  Furthermore, there are ways to access the funds in your 401(k) plan prior to retirement through loans or pre-mature distributions even if you have not reached the age of 59 and a half.  A pension is completely different.  In many cases, you would not have access to any of your pension funds prior to retirement (try asking the government for an advance on your social security benefit!) and, even after you retire, you are limited to taking only the monthly benefit.  So, if you have a large expense, you may need to save-up over many months, which may not be feasible for your particular situation.

A second fundamental difference between a 401(k) plan and a pension is that you probably cannot leave any assets to your children through a pension.  Those receiving pension benefits often have the option of selecting a benefit that will provide income to a surviving spouse; however, the pension benefit usually cannot be passed onto children.  A 401(k) plan is much more flexible in this respect in that multiple beneficiaries including spouses, children, unrelated parties, and/or even charities can be listed as beneficiaries.  For example, let’s say that Jane is married to John.  Jane has a $500,000 401(k) plan.  Jane and John both die in a plane crash and $500,000 is passed onto their surviving children.  In this example, if Jane had a $2,000 monthly pension instead of her 401(k) plan, her children would not receive anything.

Now, let’s get into the Nitty Gritty.  Assuming that Jane and John don’t care about being able to access more than $2,000 per month and they don’t care about leaving any assets to their children or charity, we can do an apples-to-apples comparison.  If Jane was offered a pension benefit of $2,000 per month or her choice of a defined contribution plan such as a 401(k) or IRA, how much money would have to be inside the defined contribution plan to make it a better option?  And for the people who say, “There’s nothing like a guaranteed pension,” I would beg to differ.  Let’s take an extreme example: if someone offered you a $1 billion IRA instead of a $2,000 monthly pension, you would obviously take the IRA.  The point is that if the IRA option provides a large enough sum of money then it make sense to take the IRA.

For comparative purposes, we’ll assume that Jane retires at age 65 and lives until age 90 (25 years).  According to the graph below from BlackRock, one can have a sufficiently high level of confidence in withdrawing 4% of his or her portfolio over a 25-year period without running out of money (I am assuming the portfolio is invested 60% in equities and 40% in bonds).  Let’s again assume that Jane has the option of either selecting a $2,000 monthly pension or a lump-sum distribution into an IRA.  Since a pension will end at Janes death, we will also assume the IRA portfolio is depleted at Janes death.  The question becomes, “How large does a portfolio need to be so that monthly distributions of$2,000 represent a 4% withdrawal rate.  $2,000 X 12 months is equal to $24,000 per year.  $24,000 is 4% of $600,000.  So the answer to the question is $600,000.  This is a very common way to compare pension benefits to lump-sum distributions/rollovers; however, one key aspect is often over looked.  This calculation assumes that the pension benefit will increase with inflation.  Often times pension benefits, especially non-public pension benefits, do not increase with inflation.  For example, assuming inflation of just 2% per year (of course inflation could be higher!), a pension that is not adjusted for inflation would lose over 21% of its purchasing power over just 10 years.  In contrast, the chart below takes inflation into consideration.  In my experience, the best way to compare a pension vs. a lump-sum distribution is to create two difference “scenarios” in financial planning software.  This way, you can see which scenario provides a higher likelihood of financial success.

Pensions can be good

Similar to my extreme example where someone would obviously take a $1 billion lump-sum rollover instead of a $2,000 monthly pension benefit, there can also be relatively outsized (and favorable) pension benefits.  In fact, one result of many poorly constructed pension systems is that companies mistakenly provide their employees with too good of a deal.  Let’s go back to the example in the first paragraph of the, “Why do you say pension plans are not actually guaranteed?” section.  Theoretically, someone could boost their pension benefit by working just three years in an extremely high paid position to obtain a very high Final Average Salary and then work at a very low paid position for the rest of his or her career to meet the requirement for the minimum number of years worked.  In contrast to a 401(k) plan where one would need to maintain a high salary (and consequently high contributions to a 401(k) plan), this would be a great way to do less and get more.  Of course, this type of gamesmanship happens with pension systems, which is part of the reason why many companies no longer offer pension plans.  As long as your company doesn’t file for bankruptcy, it may be obligated to follow through on a commitment it shouldn’t have made even if it is at the expense of shareholders.

Final comments

There are a host of other issues to consider when deciding to initially elect a pension or defined contribution plan, switch out of a pension or defined contribution plan, or to take a pension or lump-sum distribution at retirement.  Furthermore, your particular financial situation will likely impact any analysis.  These are never black or white issues.  Instead, they are gray issues with many shades of gray.

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