Posted on 23 February 2011
By Mark Miller
The political turmoil and funding problems swirling around government pensions have prompted some readers to wonder whether they should just take the money and run.
The question I’m hearing: If I’m near retirement, is it better to opt for a lump sum payment on the way out the door and leave behind all this noisy, messy risk? Or, should I stick with the traditional monthly, annuity-style pension?
I addressed the lump sum question in a January column discussing private sector pensions, arguing that lump sums usually are a bad deal for workers. Most often, retirees will receive higher lifetime payments from annuity-style pensions, and the guaranteed income stream provides valuable insurance against longevity risk — that is, the risk of outliving your money.
But what about the public sector? The headlines aren’t encouraging. Governors in a handful of states are grappling with underfunded plans; in Wisconsin, public employee unions are fighting dramatic cuts in pensions and bargaining rights proposed by the governor. We’ve even seen some in Congress talking about legislation that would permit states to file for bankruptcy, tearing up labor agreements and nullifying pension obligations in the process.
Considering all the turmoil, does it make sense to take a lump sum if you’re relying on a pension from a state or municipal pension plan?
First, it’s important to remember that most government-sponsored pensions are guaranteed by state law. Unlike in the private sector, pension rights can’t be easily changed or revoked.
But it’s equally important to pay attention to the fiscal health of your plan — not to the headlines about what’s going on elsewhere around the country. While pension plans are sponsored by states and municipalities, 89 percent of active public sector participants are in state-sponsored plans, according to the Center for Retirement Research (CRR) at Boston College — and their health varies widely. Some states have kept up on annual required contributions, while others relied on the long bull market as a substitute for contributions during the past two decades.
The result is wide variation in funded ratios, which measures a fund’s assets against its liabilities to beneficiaries. Illinois, California and New Jersey are poster children for underfunding, while Florida, Georgia and Massachusetts are over-funded, according to research by CRR. (Wisconsin’s plans are 100 percent funded.)
Moreover, a pension-funding ratio refers to a plan’s ability to meet pension obligations over a 30-year period — not just tomorrow. No state plans are in danger of running out of money in the near-term, and pension finance experts expect most funds will experience cyclical rebounds when the economy improves.
Underfunded state-run pension plans likely will see changes in plan design, such as higher retirement ages for workers outside of public safety jobs, and shifts to 401(k)-style defined contribution systems. But such changes are most likely to impact younger workers and new hires who are years from retirement.
For workers close to retirement age, the annuity-style pension remains the better choice in most cases, experts say.
Taking a lump sum could mean leaving a great deal of money on the table. Most public sector workers are required to make substantial contributions to their plans from salary. But in many cases, workers who take lump sums at retirement walk away only with their own contributions — not the employer contribution or accrued interest.
Moreover, it’s not easy to replicate the lifetime income stream of a pension, which enjoys huge benefits from the efficiency of pooled investment and reduced fees.
“The question is, what would it cost to replace that pension with an immediate annuity?” says Charles Bennett Sachs, a financial planner and principal with Evensky and Katz Wealth Management. Bennett Sachs did the math for a client who teaches in Miami-Dade County in Florida who plans to retire a year from now.
She had a choice between a monthly annuity-style pension payment of $3,283 with a three percent annual cost-of-living adjustment (COLA), or a lump sum of $540,000. The cost to replace that monthly income with a single premium income annuity with that same three percent COLA: $875,000.
Resources: For a closer look at public sector pension decisionmaking, see a longer article I wrote recently on the subject at Reuters Prism Money.