The Problems with Pensions

Today we are seeing fewer pensions than we did 20 years ago. Here's the reason for this downward trend: Pensions are facing systemic problems, which is why we see private sector companies replacing these defined benefit plans with defined contribution plans, such as 401(k)s.

There was a time when employees worked until they could no longer physically do their job, and when they retired they died shortly after. Today we see employees retiring much sooner in the cycle and living longer, which translates to significantly higher pension costs that are simply unsustainable.

Speaking of sustainability, historically, pensions have used 4.5% to 7.5% to calculate their projection of benefits. With interest rates far below this range, it goes a long way in improving the optics of the plans, but it does very little to change their actual solvency.

Interest rates have been far below these percentages for decades. When you couple that fact with a projected 10-year benefit period you can see how the math appears great on paper. The reality is that if someone retires in their 50s (which is most often the case when a pension is involved) and lives well into their 70s and 80s, you can see that 10-year estimates are short of reality.

Nearly 1 million working and retired Americans are currently covered by pension plans that are in imminent danger of insolvency, according to a Daily News article

So, what happens if a pension is unable to pay its promised benefits? According to The Heritage Foundation, the Pension Benefit Guaranty Corporation (PBGC), which is similar to the FDIC, found that for a promised benefit of $24,000 a year, they are insured only up to $12,870.

To compound the problem, this insurance has the same problem as the FDIC. The FDIC has billions in reserves but has exposure to trillions of dollars in bank accounts. The same issue exists within the PBGC. The promise of insurance benefits is not mathematically supported. If PBGC goes insolvent, that $12,870 promise is really only able to cover $1,500 under the insurance benefit.

The concern here is that when you retire and are relying on an annuity payment from a pension, you are placing a lot of trust in the pension calculations. If the calculations are off, there is not enough insurance to recover the loss.

A Lump Sum Gives You More Control of Your Assets

I began this article by suggesting that the decision to take a pension annuity payment over an available lump sum option often rests on which option provides the greatest income. When you add it all up, the decision to accept a lump sum offer is more about controlling and preserving your future income sources than it is the annuity payment you are promised from the pension.

Now, I am not suggesting that all pensions are destined to go broke, but you should consider this possibility when structuring the income sources that are designed to sustain you for the rest of your life.

By accepting a lump sum from the pension, you gain control over your income assets. Even if the income generated from the lump sum is less than the promised annuity payment from the pension, you gain control over the assets.

Even without the risk of a default, this lump sum option is a significant factor when you consider the following:

• Your income needs can fluctuate in your years of retirement from Phillips 66, and the control of the assets backing your income gives you the flexibility to meet your income needs.
• You’re in a better position to take care of your spouse if you were to predecease them by owning the assets and leaving them behind for your spouse to continue to receive income.
• Your heirs can be the beneficiary of the assets after you and your spouse pass when a pension is guaranteed to disinherit your heirs since it doesn’t pass to your children. In some cases, a child could receive a vested portion of the pension not already paid out.
• You have access to the assets if there comes a time in your life when you may need cash, and having control over the assets grants you that option.

If You Must Go with an Annuity, Single-Life Option Gives You More Control

Of course, not all pensions have a lump sum option, which means you have no choice but to accept an annuity payment . For our Phillips 66 clients that this applies to, there are a few things to consider before selecting your irrevocable annuity option.

As with a lump sum, the idea is to move as much into your control as possible. It can be tempting to accept a reduced benefit to support a spouse or loved one after your passing, but this option only hands more control over to the pension.

How to Offset Lower Social Security Benefits When a Spouse Dies

A single-life annuity option is often your highest monthly benefit, and it is the quickest way to get the most from the pension in the shortest period of time. The downside to electing this option is that it can leave your spouse with an income shortage because payments would stop after your passing. That is why if you are married and choose to make this election, your spouse must sign off on that decision.

So, you have two options to protect your spouse:

• You can buy insurance outside of the pension. With this option you would accept the single-life benefit, taking the highest annuity payment and then paying a premium to an insurance contract that would pay a lump sum to the surviving spouse or children if you predecease them. This approach also gives you the flexibility of canceling the policy if circumstances change and the benefit is no longer needed.
• Or you can buy insurance through the pension. In this case, you would go for a joint-and-survivor annuity, electing to take a reduced annuity payment in exchange for the benefit to continue to your spouse if you were to predecease them. Essentially, you are paying for the insurance with your lower benefit amount. It is worth mentioning that this benefit only has one beneficiary, so it would disinherit the children if you choose this option.

A Roth IRA conversion decision hinges on your full tax picture, including the employer benefits Phillips 66 provides. According to publicly available information, Phillips 66 maintains a cash balance pension plan, which defines your retirement benefit as a hypothetical account balance that grows over your career through pay credits and interest credits. Under ERISA, cash balance plan benefits vest on a three-year cliff schedule. Phillips 66 also offers retiree healthcare benefits to eligible employees. Because the specifics of your cash balance account balance, vesting status, and benefit options depend on your individual employment history and plan documents, We encourage you to review your Summary Plan Description (SPD) or speak with Phillips 66's HR or benefits team for the most current details.

The Hidden Costs of a Joint-and-Survivor Benefit

One important factor when going with a joint-and-survivor annuity is the cost of buying the insurance through the pension. Of course, you have premiums in either scenario but when purchased within a pension there are unique circumstances that most people completely overlook.

If your pension has a cost-of-living adjustment built into it, you should recognize that because a joint-and-survivor benefit is lower, it will receive a smaller cost-of-living increase than a single-life benefit would, which means that the difference between what the maximum benefit and the reduced benefit would be compounds over time. That translates to an ever-increasing cost of insurance against inflation.

Here's an example: Say you have a maximum benefit of $5,000 per month with a single-life annuity, and a reduced benefit $4,000 per month with a joint-and-survivor annuity. That leaves you with a monthly cost for the insurance of $1,000 per month. When you factor in a cost-of-living adjustment of 3%, that is 3% on the benefit being received. So 3% on $5,000 would be $150, whereas 3% on $4,000 would be $120, a difference of $30 per month. This income gap compounds over time. Projected out over 20 years, the gap grows to over $1,800 per month.

If that wasn’t enough of a reason to not buy the insurance from the pension, consider the fact that the longer the pension recipient lives, the fewer years the spouse is receiving the insurance from the pension. When you think about this, buying the insurance from the pension means that you are accepting an arrangement where you are paying an ever-increasing monthly premium for a decreasing benefit.

Unlike a life insurance policy purchased outside of the pension system, this pension insurance for the spouse only extends to your spouse, unless you were to choose a child as the beneficiary.

Be Careful

Now, if you go with a single-life annuity and choose to purchase insurance outside of the pension system, it is critical that the type of policy you purchase and the amount of insurance obtained are in alignment with what you need to protect your family. One misstep in this process can leave your policy at risk of lapsing or expiring, leaving your spouse vulnerable to a significant income gap.