In the last few decades, pension plans have become less common for retirees, especially in the private sector. A qualified retirement plan such as a pension benefit (not to be confused with a more common 401(k) or similar employer retirement savings plan) is a somewhat old-fashioned, old-school pension retirement plan. Employees nearing retirement from companies that offer these benefits typically receive a participant benefit statement, which contains their date of birth, date of hire, and a host of payout options known as annuities based on a pre-determined number from a pension mortality table.
An annuity is a contract designed for the person who chooses to forsake the responsibility of making investment decisions, and assigns that risk to an annuity company or insurance company. The retiree invests a certain amount of money in the way of premiums, known as the accumulation phase, with the company. This company promises to invest the money and pay the employee a specific amount for the rest of the investor’s life. This period is known as the annuitization phase. Upon death, the policy terminates and all undistributed funds stay with the company. In essence, the company is wagering that the policy will outlive the policy holder.
The employee has two choices: go the annuity route, or invest for himself or herself. This requires analysis. The employee should consider contacting a financial advisor to analyze their pension benefit statement to determine their payout options. The financial advisor would look at the payout options, which generally include single-life, 50% joint and survivor, 75% joint and survivor, 10-year certain and life, 10-year certain only, and perhaps a dozen others with various terms and payout options. The financial advisor will also ask the prospective client about his or her current health and health history, family health history, and life expectancy. Assuming normal health for the investor (if the client suffers from a chronic or life-threatening illness, this can change the entire dynamic), the investment advisor estimates monthly amounts the client is going to receive, and calculates an internal rate of return on various options. As the fiduciary, my responsibility is what is in my client’s best interest. As such, the factors that I consider before I determine policy choices include the mindset of the client and what the client is most comfortable with.
Typically, there are three different annuity options worth analyzing: single-life, 50 or 75% joint survivor, and 10-year certain and life. Let’s look at these more closely.
For single-life policies, the employee starts receiving the benefits on a monthly basis. Upon death of the policy holder, the benefits terminate and are not passed on to the surviving spouse. These plans pay out slightly more on a monthly basis, as the insurance company has calculated that the policy holder will die sooner than his or her life expectancy, in which case the company retains all of the undistributed money. This scenario is disastrous for the surviving partner because when the policy holder dies, the monthly payments stop.
The second annuity is a 50% or 75% joint survivor. Here, the employee receives a fixed dollar amount up until his or her death, then the surviving partner receives that percentage (50 or 75%) for the balance of his or her life. This means more safety and peace of mind for the client and spouse. For the annuity or insurance company, it means their actuarial calculations must take into account two lives, not just one, when determining the monthly payouts. Because there is a greater chance of survivorship, the risk goes up for the company. This increased risk translates into a smaller monthly annuity amount.
The last annuity that we would typically look at is some type of certain payment option. For example, in a 10-year certain annuity, if the policy holder should die prior to the 10-year expiration date, the beneficiary will recoup the unpaid balance of the policy based on the remaining unpaid through the original 10th year. On the other hand, should the client die past year 10, the payments stop and the insurance company “wins.”
When advising clients, financial advisors prepare an internal rate of return calculation looking at all three of these options. The reason planners prepare an internal rate of return type of analysis is to determine the investment performance based on the anticipated life expectancy of the policy holder. The longer the policy holder lives, the less money is kept by the insurance company. Typically, the breakeven point from an internal rate of return is around age 78–80. If the policy holder dies before this age, it’s a windfall for the company. If they live past this age, the client wins because he or she starts to make money off of the monthly annuity payments. The company’s calculation that the client would die sooner is not realized, and is thereby saddled with more payments than it expected.
Rather than going with the annuity or insurance company, the employee may decide to take a lump sum from the employer and invest the money on his or her own. By taking on the investment burden, the employee is guessing (certainly hoping), in essence, that the annuity or life insurance contract is wrong about his or her life expectancy.
With the help from an advisor, the employee takes the investment risk, meaning they are responsible for finding appropriate investments—whether it’s Exchange Traded Funds, Mutual Funds, or individual stocks and bonds—and putting together a portfolio themselves, typically in an Individual Retirement Account (IRA). The planner would want to do this in a tax-deferred method and in a qualified rollover manner method. The advisor can use certain parameters, say, maybe 4%–6% of return a year, and use those parameters to determine how much to draw that would be the same or comparable amount to any of the other three annuity payment options. Typically, they’re all within a few hundred dollars per year. For the investor, this eliminates the life insurance or the annuity company from taking some benefits away from him or her. That saving is obviously a good thing, but it leaves the investor with the burden and responsibility of providing more investment return from the IRA than he or she would have gotten from the insurance or annuity company.
Another major benefit of having an IRA is the control it provides you over your finances. If something extraordinary were to happen, such as a catastrophic event, you’d have that money available to you to deal with those circumstances. If the money was left with the annuity company or life insurance company, that money is theirs to control forever and you can only receive the agreed-upon monthly payment.
As financial advisors, we are fiduciary-bound to give the best advice to our clients, as if we were in their shoes. Some people prefer to be relieved of investment burden and put it in the hands of financial experts. They choose and are completely comfortable with getting the annuity and the pension payout as opposed to taking on the investment risk.
That’s the analysis that’s done typically when an employee/soon-to-be retiree receives a pension benefit statement. The numbers can be dizzying and the choices confusing, but choosing a competent, fee-only financial advisor is critical so that you understand all of the options and you can make a well-informed decision.
Bottom line is it comes down to risk-shifting. It’s a decision on whether or not you want to take on the investment risk personally with the help of a financial advisor, or if you want to leave the risk with the annuity or insurance company, and the employee or surviving partner will just receive a monthly check year in and year out.