Adrian A. Hedwig
Financial Advisor, CUSO Financial Services, L.P.
Available at all Salal Credit Union branches
Is it Wise to Trade Your Pension for a Lump Sum?
Most private employers have already replaced traditional pensions, which promise lifetime income payments in retirement, with defined contribution plans such as 401(k)s. But 15% of private-sector workers and 75% of state and local government workers still participate in traditional pensions.1 Altogether, 35% of workers say they (and/or their spouse) have pension benefits with a current or former employer.2
Many pension plan participants have the option to take their money in a lump sum when they retire. And since 2012, an increasing number of large corporate pensions have been implementing “lump-sum windows” during which vested former employees have a limited amount of time (typically 30 to 90 days) to accept or decline buyout offers.3 (Lump-sum offers to retirees already receiving pension benefits are no longer allowed.)
By shrinking the size of a pension plan, the company can reduce the associated risks and costs, and limit the impact of future retirement obligations on current financial performance. However, what’s good for a corporation’s bottom line may or may not be in the best interests of plan participants and their families.
For many workers, there may be mathematical and psychological advantages to keeping the pension. On the other hand, a lump sum could provide financial flexibility that may benefit some families.
Weigh risks before letting go
A lump-sum payout transfers the risks associated with investment performance and longevity from the pension plan sponsor to the participant. The lump-sum amount is the discounted present value of an employee’s future pension, set by an IRS formula based on current bond interest rates and average life expectancies.
Individuals who opt for a lump-sum payout must then make critical investment and withdrawal decisions, and determine for themselves how much risk to take in the financial markets. The resulting income is often not enough to replace the pension income given up, unless the investor can tolerate exposure to stock market risk and is able to achieve solid returns over time.
Gender is not considered when calculating lump sums, so a pension’s lifetime income may be even more valuable for women, who tend to live longer than men and would have a greater chance of outliving their savings.
In addition, companies might not include the value of subsidies for early retirement or spousal benefits in lump-sum calculations.4 The latter could be a major disadvantage for married participants, because a healthy 65-year-old couple has about a 73% chance that one spouse will live until at least 90.5
About 41 million people are participants (active, retired, or separated vested) of PBGC-insured corporate pension plans.
—Source: Congressional Budget Office, 2016
When a lump sum might make sense
A lump-sum payment could benefit a person in poor health or provide financial relief for a household with little cash in the bank for emergencies. But keep in mind that pension payments (monthly or lump sum) are taxed in the year they are received, and cashing out a pension before age 59½ may trigger a 10% federal tax penalty.6 Rolling the lump sum into a traditional IRA postpones taxes until withdrawals are taken later in retirement.
Someone who expects to live comfortably on other sources of retirement income might also welcome a buyout offer. Pension payments end when the plan participant (or a surviving spouse) dies, but funds preserved in an IRA could be passed down to heirs.
IRA distributions are also taxed as ordinary income, and withdrawals taken prior to age 59½ may be subject to the 10% federal tax penalty, with certain exceptions. Annual minimum distributions are required starting in the year the account owner reaches age 70½.
It may also be important to consider the health of the company’s pension plan, especially for plans that don’t purchase annuity contracts. The “funded status” is a measure of plan assets and liabilities that must be reported annually; a plan funded at 80% or less may be struggling. Most corporate pensions are backstopped by the Pension Benefit Guaranty Corporation (PBGC), but retirees could lose a portion of the “promised” benefits if their plan fails.
The prospect of a large check might be tempting, but cashing in a pension could have costly repercussions for your retirement. It’s important to have a long-term perspective and an understanding of the tradeoffs when a lump-sum option is on the table.
1 U.S. Bureau of Labor Statistics, 2016
2 Employee Benefit Research Institute, 2016
3, 4 The Wall Street Journal, June 5, 2015
5 Society of Actuaries, 2017
6 The penalty doesn’t apply to employees who retire during or after the year they turn 55 (50 for qualified public safety employees).
Don’t Let Rising Interest Rates Catch You by Surprise
You’ve probably heard the news that the Federal Reserve has been raising its benchmark federal funds rate. The Fed doesn’t directly control consumer interest rates, but changes to the federal funds rate (which is the rate banks use to lend funds to each other overnight within the Federal Reserve system) often affect consumer borrowing costs.
Forms of consumer credit that charge variable interest rates are especially vulnerable, including adjustable rate mortgages (ARMs), most credit cards, and certain private student loans. Variable interest rates are often tied to a benchmark (an index) such as the U.S. prime rate or the London Interbank Offered Rate (LIBOR), which typically goes up when the federal funds rate increases.
Although nothing is certain, the Fed expects to raise the federal funds rate by small increments over the next several years. However, you still have time to act before any interest rate hikes significantly affect your finances.
Adjustable rate mortgages (ARMs)
If you have an ARM, your interest rate and monthly payment may adjust at certain intervals. For example, if you have a 5/1 ARM, your initial interest rate is fixed for five years, but then can change every year if the underlying index goes up or down. Your loan documents will spell out which index your ARM tracks, the date your interest rate and payment may adjust, and by how much. ARM rates and payments have caps that limit the amount by which interest rates and payments can change over time. Refinancing into a fixed rate mortgage could be an option if you’re concerned about steadily climbing interest rates, but this may not be cost-effective if you plan to sell your home before the interest rate adjusts.
It’s always a good idea to keep credit card debt in check, but it’s especially important when interest rates are trending upward. Many credit cards have variable annual percentage rates (APRs) that are tied to an index (typically the prime rate). When the prime rate goes up, the card’s APR will also increase.
Check your credit card statement to see what APR you’re currently paying. If you’re carrying a balance, how much is your monthly finance charge?
Your credit card issuer must give you written notice at least 45 days in advance of any rate change, so you have a little time to reduce or pay off your balance. If it’s not possible to pay off your credit card debt quickly, you may want to look for alternatives. One option is to transfer your balance to a card that offers a 0% promotional rate for a set period of time (such as 18 months). But watch out for transaction fees, and find out what APR applies after the promotional rate term expires, in case a balance remains.
Variable rate student loans
Interest rates on federal student loans are always fixed (and so is the monthly payment). But if you have a variable rate student loan from a private lender, the size of your monthly payment may increase as the federal funds rate rises, potentially putting a dent in your budget. Variable student loan interest rates are generally pegged to the prime rate or the LIBOR. Because repayment occurs over a number of years, multiple rate hikes for variable rate loans could significantly affect the amount you’ll need to repay. Review your loan documents to find out how the interest rate is calculated, how often your payment might adjust, and whether the interest rate is capped.
Because interest rates are generally lower for variable rate loans, your monthly payment may be manageable, and you may be able to handle fluctuations. However, if your repayment term is long and you want to lock in your payment, you may consider refinancing into a fixed rate loan. Make sure to carefully compare the costs and benefits of each option before refinancing.
The Health-Wealth Connection
It’s a vicious cycle: Money is one of the greatest causes of stress, prolonged stress can lead to serious health issues, and health issues often result in yet more financial struggles.¹ The clear connection between health and wealth is why it’s so important to develop and maintain lifelong plans to manage both.
The big picture
Consider the following statistics:
1. More than 20% of Americans say they have either considered skipping or skipped going to the doctor due to financial worries. (American Psychological Association, 2015)
2. More than half of retirees who retired earlier than planned did so because of their own health issues or to care for a family member. (Employee Benefit Research Institute, 2017)
3. Chronic diseases such as heart disease, type 2 diabetes, obesity, and arthritis are among the most common, costly, and preventable of all health problems. (Centers for Disease Control and Prevention, 2017)
4. Chronic conditions make you more likely to need long-term care, which can cost anywhere from $21 per hour for a home health aide to more than $6,000 a month for a nursing home. (Department of Health and Human Services, 2017)
5. A 65-year-old married couple on Medicare with median prescription drug costs would need about $265,000 to have a 90% chance of covering their medical expenses in retirement. (Employee Benefit Research Institute, 2017)
Develop a plan for long-term health …
The recommendations for living a healthy lifestyle are fairly straightforward: eat right, exercise regularly, don’t smoke or engage in other risky behaviors, limit soda and alcohol consumption, get enough sleep (at least seven hours for most adults), and manage stress. And before embarking on any new health-related endeavor, talk to your doctor, especially if you haven’t received a physical exam within the past year. Your doctor will benchmark important information such as your current weight and risk factors for developing chronic disease. Come to the appointment prepared to share your family’s medical history, be honest about your daily habits, and set goals with your doctor.
Other specific tips from the Department of Health and Human Services include:
Nutrition: Current nutritional guidelines call for eating a variety of vegetables and whole fruits; whole grains; low-fat dairy; a wide variety of protein sources including lean meats, fish, eggs, legumes, and nuts; and healthy oils. Some medical professionals are hailing the long-term benefits of the so-called “Mediterranean diet.” Details for a basic healthy diet and the Mediterranean diet can be found at health.gov/dietaryguidelines.
Exercise: Any physical activity is better than none. Inactive adults can achieve some health benefits from as little as 60 minutes of moderate-intensity aerobic activity per week. However, the ideal target is at least 150 minutes of moderate-intensity or 75 minutes of high-intensity workouts per week. For more information, visit health.gov/paguidelines.
“Always keep two things in stock: crunchy vegetables and an emergency savings account.”
—Michael F. Roizen, MD, and Jean Chatzky, personal finance commentator and authors of Ageproof: Living Longer Without Running Out of Money or Breaking a Hip
… And long-term wealth
The recommendations for living a financially healthy life aren’t quite as straightforward because they depend so much on your individual circumstances. But there are a few basic principles to ponder:
Emergency savings: The amount you need can vary depending on whether you’re single or married, self-employed or work for an organization (and if that organization is a risky startup or an established entity). Typical recommendations range from three months’ to a year’s worth of expenses.
Retirement savings: Personal finance commentator Jean Chatzky advocates striving to save 15% of your income toward retirement, including any employer contributions. If this seems like a lofty goal, bear in mind that as with exercise, any activity is better than none — setting aside even a few dollars per pay period can lead to good financial habits. Consider starting small and then increasing your contributions as your financial circumstances improve.
Insurance: Make sure you have adequate amounts of health and disability income insurance, and life insurance if others depend on your income. You might also consider long-term care coverage.²
Health savings accounts: These tax-advantaged accounts are designed to help those with high-deductible health plans set aside money specifically for medical expenses. If you have access to an HSA at work, consider the potential benefits of using it to help save for health expenses.