Everyday I get a new question regarding pensions. Almost all of these stem from a fellow co-worker who’s part-time gig is armchair financial advisor. Today, my client was shocked to hear from fellow automobile design engineer/lump sum expert, that he would only receive 45% of the lump sum, because the other 55% were eaten away by taxes. My clients co-worker wasn’t even close, and worse I wouldn’t be surprised if he was told this by his own financial advisor. Below is a list of myths, or just plain mistakes, that I have heard about pensions.
Myth: You are taxed on the lump sum the day you receive it
Let’s start with the one I got today, and one I hear often. The misconception that when you receive your lump sum payment, you pay taxes on the full amount immediately. The fact is there is some truth to this statement. If you are naive enough to take the lump sum and deposit into your checking/savings/taxable brokerage account, then yes, it would all be taxable to you. Thankfully, I haven’t met a person yet, that has made this gigantic mistake.
Instead of depositing the lump sum into a checking account and paying all the taxes now, we roll over the lump sum into an IRA or existing 401(k). The full amount of the lump sum is rolled over tax-deferred, and there are no taxes until you start taking distributions from the account. Then, you are only taxed on the amount you withdraw, and not the full amount. These taxes are much lower than withdrawing your full lump sum all at once.
Myth: If my company goes out of business, I lose my monthly pension
One of the reasons that many people tell me they decide to take the lump sum, is that they think their company won’t be around for the next 30 years to pay the monthly pension. This is a valid concern, giving that we are in Michigan, and we have seen a lot of good, and a lot of not so good times in the car industry. If I take my lump sum, I control the funds instead of letting my company, which I may not trust, control the money.
The problem with this statement, is that many people forget about the Pension Benefit Guaranty Corporation (PBGC). The PBGC is essentially a government sponsored, but not the government, insurance company. The PBGC steps in and pays your monthly pension in the case that your company can’t any longer. Companies make insurance payments to the PBGC when they are healthy, with the promise that their employees will have protection in the case they fail. Certainly, there are some concerns with the PBGC, but you should feel pretty comfortable receiving your pension, no matter how unhealthy your company. This leads us to the next myth.
Myth: The PBGC only pays pennies on the dollar if my company goes bankrupt
Here in Michigan, this myth is almost always the direct result of someone knowing an employee of Delphi, when Delphi went bankrupt. Let me paint you a picture of the story that I hear often. The Delphi employee was going to receive a $4,000 per month pension when he retired at age 60, but instead will only get $1,800 from the PBGC. $1,800 is a drop in the bucket compared to $4,000, therefore he is only getting a fraction of what he promised. Much like many myths, this has some truths to it as well.
The PBGC pays out a certain amount, which is based on the age of the employee when his company goes bankrupt. In 2018, the maximum PBGC monthly payout is $1,880 if you are 50 when your company goes bankrupt. The maximum guaranteed amount though goes up as you get older. For example, at age 60 the maximum monthly payout is $3,523 and at age 65, it is over $5,000 per month. For many people, these types of payouts are higher than your promised pension, therefore you should be fully insured. The issue with a lot of the Delphi pensions was there was a lot of younger workers promised large pensions, but only got a small amount based on their age. People close to retirement age probably won’t have this same issue.
Myth: The lump sum payment is the amount that my company is willing to buy me out
Many people believe that the lump sum is just some random number that a company decides is the right amount to not have to pay you the pension. In fact, the company has very little or no influence on the actual lump sum number. Really, the lump sum is simply just the present value of your future pension payments, calculated until your life expectancy. Most companies, including Ford and GM, will use a government table for current interest rates and the lump sum will change based on these interest rates. As interest rates go up, the lump sum goes down, and vice versa. Your company may choose different interest rate calculations, but have almost no influence on your lump sum total.
Myth: I am better off taking the lump sum and buying a private annuity
I’m not sure I would call this a myth, rather just a mistake I see some people make. Again, this stems from the fact that people trust an insurance company, the annuity, to stay in business longer than their current company so would rather take an annuity from the insurance company. There are two big reasons why this typically doesn’t make sense:
- Insurance companies are for-profit organizations, and they typically charge a fairly hefty fee when you buy an annuity. Not to mention, the salesperson is also receiving a commission. Add up these fees and commissions, and an annuity offered by a life insurance company, is almost never as good as the free one offered by your company. Expect to receive 5 to 15% less from a private annuity than from your company.
- If you purchase the annuity from a life insurance company you are giving up the PBGC insurance. Although life insurance companies have some state protection, it is not as robust as the PBGC protection
Be weary of a financial advisor advising to take the lump sum and buy an annuity from him. This may be in the best interest of the annuity salesman, but probably not yourself.
Your pension decision will ultimately be one of the biggest financial decisions you make in retirement. I strongly suggest ignoring those co-workers that are dead set on one option over the other. Talk with your financial advisor, and make a decision which is best for you.