Imagine working for a company for 40 years and finally making the decision to retire. Your financial situation looks great. A nice pension from your company as well as social security benefits for you and your wife. You figured that you would have plenty of income in retirement to live comfortably. Then the unimaginable happened. Shortly after you retire, you pass away. Leaving your wife with only 50% of your original pension and only one social security check. Suddenly that secure retirement, wasn’t looking so great for your surviving spouse.
The scenario above is one risk of the monthly pension. This article discusses some of the risks of the monthly pension vs. a lump sum option.
In my opinion, the biggest risk of the monthly pension is high inflation. Most pensions don’t have a cost of living adjustment (COLA). Therefore, your pension becomes less valuable every year. If inflation is around 3.5% per year, your pension loses about half of its value every 20 years. Many people expect that the easy money period of quantitative easing that we have had over the past 10 years will actually cause higher inflation in the future. A high inflation rate can cripple a monthly pension with no COLA.
A few years back the unimaginable happened to one of my clients. She was diagnosed with brain cancer and was only given a few months to live. At that time she decided to retire and take the lump sum. This way her husband would be able to keep the full amount of the pension when she passes. Unfortunately, before she was officially retired, she passed. The company rule was that if someone passes before officially retired, the remaining spouse will collect a monthly pension based on 65% of the value of the original pension. In this case, her family got the short end of the stick.
The longer you live, the better the pension. If you pass away early and are married, your spouse will get only a small percentage of the original amount. If you are not married, the pension is typically gone. Work at a company for 30 years and the kids have nothing to show for it if you pass early. No, leaving a large inheritance may not be your goal, but still, better than letting the company keep all of that money. The longer your life expectancy, the more beneficial the monthly pension. Of course the longer you live, the more inflation will impact your monthly pension.
Another pension story which a recent client experienced. He retired, so he thought, prepared to spend his retirement years on the golf course. And that is exactly what happened, for about two years. He got bored, was offered a nice contract position with minimal work and good pay, and decided to go back to work. At that point he didn’t need his monthly pension, his new work was plenty, but it kept coming. This means that he was receiving a good amount of income and paying a ton of income taxes on money he doesn’t need. There are certainly bigger problems than making too much money. However, he may have been better off investing the funds and letting it grow. Once a monthly pension starts, it typically can’t be stopped, and that can be a problem.
My feeling is that your goal in retirement should be to maximize your income and enjoyment, and not your kids inheritance. A monthly pension typically maximizes your income in retirement, where a lump sum will typically maximize your children’s income when you pass. As discussed in the previous section, once you (and if you are married your spouse) passes away, the monthly pension is gone. If your goal is to pass on as much as you can to your children or maybe a charity, the monthly pension may not be the right choice for you. You have probably heard of the 4% rule, which states that you can safely withdraw 4% per year from your retirement savings. I have written before how I think that you actually should feel better about withdrawing more than that, but still 4% is a rule of thumb that many people believe. I find that the yearly withdrawal from the monthly pension is many times is 5 or 6% of the lump sum amount.
The Pension Benefits Guaranty Corporation (PBGC) is a safety net, which helps pay your pension if your company is unable. What happens however if your safety net also has a hole? The PBGC is basically an insurance policy that companies make premium payments when they are in business. If that company becomes insolvent however, the PBGC jumps in and helps pay your pension. Unfortunately, as pensions have decreased, so have those insurance payments that companies have been making. The good news is that the PBGC has roughly $100 billion in assets. The bad news, is that they estimate future losses due to underfunded plans to exceed $240 billion. The PBGC is not the government, however it is a government agency, and could potentially could get bailed out in the case of financial disaster.
The other issue; your pension might not be backed by the PBGC. You may wonder why the PBGC didn’t step in and help city of Detroit employees when the city went bankrupt. The PBGC protects private employees, but typically doesn’t cover state, city or county workers. There is no question that public pensions have some huge deficits, and there is no PBGC coming to bail them out.
I’m a big fan of the monthly pension and I think it makes sense for most people to choose the monthly pension over a lump sum. I wrote here, some of the reasons why I prefer the monthly pension for many people. However, like most financial decisions, it doesn’t come without risks. It’s important that you understand those risks before making a very big decision like the monthly pension.
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