Apr 02, 2019 - Knowledge@Wharton
The U.S. Treasury department’s move last month to allow private companies to pay lump-sum pension payments to retirees and beneficiaries, instead of monthly payments, is good news for companies that do not want to be saddled with long-term pension obligations – particularly for private sector employers who have underfunded pension plans.
However, lump-sum pension payments may not work out well for retirees who opt for them. While a debate has ensued on the merits and risks of lump-sum pension payments for employees, there are also wider concerns about the long-term impacts on the entire economy when retirees do not have sufficient financial resources to support themselves. Those concerns are assuming a new importance because of the rapid growth of the so-called gig economy with temporary workers and freelancers who don’t enjoy employer-sponsored retirement benefits.
The Treasury department’s latest move reverses an Obama-era pledge to bar employers from offering lump-sum payments. The fear was that those receiving a lump-sum payment might be shortchanged and also might be tempted to spend the money sooner. Around 26.2 million Americans receive pensions right now, though that number has been declining as businesses favor 401(k) plans instead.
How Companies Gain
Defined-benefit plans are pensions that provide beneficiaries with a monthly benefit check for as long as they live. Defined contribution plans stipulate only the contributions to an employee’s account each year. “The concern with companies offering defined-benefit plans is that they need to manage carefully around future mortality, around investment fluctuations, and so forth,” said Olivia Mitchell, executive director of the Pension Research Council at Wharton and director of the Boettner Center on Pensions and Retirement Research. Mitchell is also a professor of insurance and business economics at Wharton.
“Many companies have had a hard time making sure their plans remained fully funded, and probably most corporate defined-benefit plans today are not fully funded,” Mitchell continued. “By offering both workers and retirees a lump sum, corporations could take the defined-benefit obligation off their books.” The move could help companies like General Electric, which has an approximately $30 billion shortfall in its defined-benefit pension plan.
Elizabeth Kennedy, professor of law and social responsibility at the Sellinger School of Business at Loyola University in Maryland saw the Treasury’s move hurting wider sections of society over time. “I see this as a shift not only of risk from the employer to the employees, but also to all of us collectively, as the question arises of what happens when folks don’t manage [their lump-sum pension payments] well — certainly not as well as their employers,” she said. “The rest of the social safety net is even further strained when [retirees’] defined-benefit plan runs out.”
Mitchell and Kennedy shared their insights on lump-sum pension payments, underfunded plans and the hidden costs of the Treasury department’s action on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)
To Lump Sum or Not?
Lump-sum payments might be the right option in some cases. “What used to be seen as the golden method of caring for people in retirement — namely defined-benefit plans — is long gone,” Mitchell said. “Many financially cogent people might say, “Gee, I work for a company which is only 80% funded. Maybe I should take the lump sum and run, while the getting is good.”
“The whole defined-benefit edifice is in ruins. I don’t see any way to fix it easily.”–Olivia Mitchell
Mitchell said she understands why a lump-sum payment is attractive, “not just for people who make mistakes, but for people who are smart about it.” However, lump-sum payments may not be the best option if an individual uses the money as monthly income. She pointed to what she called the “lump-sum illusion.” Somebody who gets a lump sum of say, $100,000, might think they are suddenly rich, but that money doesn’t go very far, she noted. Based on annuity estimates, a $100,000 payment would provide a monthly income of $560 for a 65-year-old male, and $530 for a female, because women live longer than men, she said. Even $500,000 is not a lot of money, she added.
But a lump-sum payment could help many older people who are entering retirement with far more debt than they did in the past, said Mitchell. “Baby boomers are getting into retirement not having paid off their mortgages, and not having paid off their credit cards,” she added, citing research conducted using the Health and Retirement Study (sponsored by the National Institute of Aging and the Social Security Administration), where she is a co-investigator. “A lump sum in such cases could really help older people pay off their debt and move into retirement less exposed to interest rate fluctuations.”
The Impact of the Gig Economy
Kennedy noted that the composition of the workforce has changed in recent years. She referred to the gig economy, the sharing economy and the rise of independent contractors, who tend to work in temporary jobs throughout their careers.
“While the defined contribution plan from a single employer perspective looks perhaps like a thing of the past, the burden is on us collectively to think about the solution for the future,” she said. “How do you have workers who are going to be making perhaps low wages over a course of their lifetime with a variety of employers in any meaningful way accrue meaningful, defined contribution plans that result in something more than just a few hundred dollars a month later on?”
Kennedy said that if many among the 26.2 million people that currently receive monthly pensions are lured by “the dangling of the shiny lump sum,” the so-called “gold standard” of retirement income is diminished even further. She wondered about how that would affect those dependent on employer-sponsored 401(k) plans and Social Security. Workers who have high incomes or are “incredibly savvy” contribute substantially to their 401(k) plans and get matching employer contributions would of course be better off that those who are not, she noted.
According to Mitchell, the “defined contribution” 401(k) model has been “exceptionally positive” for those who did not have an opportunity to be in defined-benefit plans that required them “to stay for life and never leave your employer.” Although she found defined contribution plans “much more appealing,” she said they fell short in that they did not have a way to protect against “longevity risk at the point of retirement…. So, I favor putting an annuity back into a defined contribution plan, so that people can, in fact, protect against living too long.”
“A lump sum in such cases could really help older people pay off their debt and move into retirement less exposed to interest rate fluctuations.”–Olivia Mitchell
An Overhang of Underfunding
Retirees may have dwindling options in securing their future incomes as defined-benefit plans have failed to provide the protections they were designed for. Mitchell noted that the 1974 Employee Retirement Income Security Act sought to ensure that defined-benefit plans are fully funded to make good on the promises offered to retirees.
“Unfortunately, in the establishment of the act and some of the institutions surrounding that, they didn’t quite get it right,” Mitchell said. For example, while it established the Pension Benefit Guaranty Corporation (PBGC) to back up corporate defined-benefit plans if the corporations go bankrupt and there’s not enough money in the plans, “the premiums weren’t set right,” both for single employer plans and multiple-employer, unionized plans, she added. “As a consequence, not only are corporate plans troubled financially now, but the backup entity that’s supposed to be insuring the defined-benefit plans also is in dire straits.”
According to Mitchell, the multiple employer system is within a few years of running insolvent, and the single employer plan will be unable to pay all it should pay by 2025. “So, the whole defined-benefit edifice is in ruins. I don’t see any way to fix it easily.”
To be sure, the offer of lump-sum payouts comes with riders. If a single employer plan is not at least 80% funded, retirees cannot get the full lump-sum payment, and if it is less than 60% funded, they cannot get any lump-sum payment. “Notwithstanding the Treasury department’s willingness to allow more lump sums, it’s going to depend on the funding status of the plan,” Mitchell said. “So, I don’t think people should book the trip to Las Vegas just yet.”
According to Mitchell, a significant number of corporate pension plans are likely to be funded to levels near 60%. Also, over the last 40 years, many corporations have frozen and/or terminated their defined-benefit plans, she said. “The insolvency of the PBGC, I think, is driving many people’s interest in taking that lump sum, and I sympathize with that.”
Data compiled by Bloomberg found that in 2017, 186 of the 200 biggest defined-benefit plans in the S&P 500 based on assets weren’t fully funded to the tune of $382 billion, according to a report by the news agency.
Who Manages Money Better?
Retirees taking lump-sum pension payments instead of annuity payouts could potentially lose between 15% and 20% of what they would have received over a 20- or 30-year period, according to some estimates. They are shortchanged in that way “because of complicated formulas including interest rates and mortality tables,” according to Forbes.
“Who is bearing that cost ultimately? The worker, for sure – but then all the rest of us, for whom, those social benefit programs are means-tested, and taxpayers pay for.”–Elizabeth Kennedy
Generally speaking, corporations have opportunities to manage retirement plans more efficiently than individuals can. “Typically, employers manage retirement plans less expensively — they pay fewer fees, fewer commissions, et cetera,” said Mitchell. “They can buy life annuities or pay life annuities for their workers much cheaper than what the workers could get on their own.”
Those who get a lump-sum payment could maintain tax protection if they roll it over into an individual retirement account (IRA), Mitchell continued. “But then you have to be very careful that the money that you’re investing in that IRA is not frittered away in expenses.”
Those who put their lump-sum monies in an IRA could also use it to buy themselves an annuity, said Mitchell. Here again, she had advice for both men and women, drawing from the fact that women live longer. “If you’re female … and if you’re in a pool with men, you’re going to get a higher benefit than you would if you went out and bought [a pension plan] on your own,” she said. “Conversely, if you’re a man, then you should take out [the pension], buy an annuity on your own, and you’ll get a higher benefit.”
Whither Social Security?
Social Security, too, is facing insolvency, Mitchell noted. “Within about 12 years, benefits will probably have to be cut for everyone by maybe 30%, or else taxes will have to go up 60% to 80%,” she said. She pointed out that Social Security benefit payouts are means-tested, where people with assets or other sources of income will get fewer benefits than those who are not as well-off. Given that, “it’s completely rational for many people in the bottom third of the wage distribution not to save at all,” she said. “If we look at the retirement picture, we have to understand the incentives we are putting in peoples’ way — or the disincentives to save.”
According to Kennedy, society at large may end up bearing the costs when corporate pension plans fail to deliver sustainable long-term benefits for their employees. “When we’re replacing a system because [large] institutions are unable to invest in ways that yield real, tangible benefits for their workers long-term, it’s hard for me to imagine that that is not replicated when many, if not most, individuals are now in that same position of managing their retirement,” she said.
“Who is bearing that cost ultimately?” Kennedy asked. “The worker, for sure — but then all the rest of us, for whom, those social benefit programs are means-tested, and taxpayers pay for. Are we just shifting the costs of mismanagement from the individuals who originally held the money to those of us who are taxpayers, who will pay for the health insurance, the care, the housing costs and all of that for folks who can no longer afford it themselves?”
Mitigating Financial Stress
Employers are sensitive to the financial difficulties of their employees, and for good reason, because financially healthy employees are more productive. “Some employers are starting to pay much more attention to what they’re calling ‘financial wellness,’” said Mitchell.
“The reason that they are working to try to help people manage their debt better, save better and budget better is that they find that it reduces employee stress,” Mitchell explained. “For example, if you’re having the credit card company or the debt collector calling you at work several times a day, that’s obviously going to make you a less productive worker.”
Some firms, especially those in the financial services sector, are integrating financial wellness features into their employee benefit packages, such as subsidies for gym memberships or fees for health wellness programs, she added. Added Kennedy: “Employers want to see their workers in many instances either succeed long-term, or at least remain with them, because the cost of turnover is so great. They want to be able to make informed decisions about workplace policy that hopefully are consistent over time.”
“If we look at the retirement picture, we have to understand the incentives we are putting in peoples’ way — or the disincentives to save.”–Olivia Mitchell
In order to facilitate companies and employees in those efforts, she called for the federal government and Congress to weigh the long-term implications of the latest move to allow lump-sum pension payments.
The Public Pension Fund Mess
Although the Treasury department notice covers only private sector pension funds, the problem of underfunding plagues public sector pension funds as well. According to estimates by The Pew Charitable Trusts, state pension funds would have had a total pension liability of $4.4 trillion in 2017, and a funding gap of $1.7 trillion.
However, favorable investment returns in fiscal 2017 and 2018 are expected to lead to a decline in pension liabilities for the next two fiscal years, according to a report in August 2018 by Moody’s Investor Services.
“Every year that goes by leads to more red ink and more concern because the state and local plans across the country have clearly not done what they should have done to contribute the right amounts, to invest their assets in their pension plans carefully and thoughtfully,” Mitchell told Knowledge@Wharton for a report on that issue.
Even as state and local government pension funds are in trouble, Mitchell did not expect them to move towards lump-sum payments. They have attempted to mitigate that financial stress in other ways. “Over the 20 years, many states have realized their defined-benefit plans are in deep trouble, and so they’ve put in place a hybrid system,” Mitchell said. That hybrid is a mix of a defined-benefit plan and a defined contribution plan, she explained. “That’s a nice mix, so that people do get the benefits of both.”
Policy Challenges
The funding crisis in pension plans will affect not just baby boomers, but also the workers who served baby boomers, such as domestic workers including nannies, housekeepers and elder-care providers, said Kennedy. She noted that home health aides and hospice care workers are part of a fast-growing segment, but independent contractors among them have few options in planning for post-retirement income. “For them, the struggle is how to save when your income is so low, in the absence of any employer contribution,” she said.
“That has impacts going up the chain to these same retirees and baby boomers who now will also have less money themselves, individually, to pay for this kind of care,” said Kennedy. She saw that crisis developing at “the intersection between retirement, savings, solvency, and the ability to meet the basic human needs of the baby boomer generation.”
Kennedy said policy makers have to focus also on workers who are “vulnerable as low-wage workers in nontraditional workplaces” in their calculations on the long-term risks they would face.