Understanding Pension Risks

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PensionsDefined-benefit pension plans are very attractive because of their promise of security. Individuals are typically guaranteed a constant stream of income throughout their retirement that will last the rest of their lives, and this means they can rely on budget projections. Karen Friedman, executive vice president and policy director of the Pension Rights Center says, “Even during a downturn, (retirees receiving pensions) know how much they’re getting on a monthly basis. They know how much they can spend.”  

In recent years, however, the security of these pensions has been challenged by many factors, including unfavorable investment returns, altering company policies, and taxpayer concerns about retirement benefits. Consider the following:

  • Around 80% of private pension plans covered by the Pension Benefit Guaranty Corp. are underfunded by $740 billion. Furthermore, only 18 defined benefit pension plans offered by some of the country’s largest companies in the S&P 500 are fully funded.
  • Over 1,400 companies closed their pension plans in 2011, compared to 1,200 in 2009. Another 152 plans failed, which meant they were unable to pay out the promised benefits and were taken over by the PBGC. The PBGC, which is funded by employer-paid insurance premiums, is currently operating a $26 billion deficit.
  • According to a report by the State Budget Crisis Task Force, public pensions are underfunded by at least $1 trillion. In order to close the gap, 35 states have minimized pension benefits for employees, and half of them have increased worker contributions to their plans. Three states – Georgia, Michigan, and Utah – have created hybrid plans that include defined contribution plans, like 401(k)s that shift some investment risk to employees.
  • Unfortunately, even fully funded plans can still face significant risks. For example, General Motors, once known as being the “model” for running a solid pension plan, shocked its salaried retirees when it announced it was unloading their pensions to Prudential Financial. Around 42,000 individuals had to decide whether to take a lump sum of their pension or trust the new provider to continue sending them monthly checks.

Friedman says that with pensions, “Everything changes. That’s the bad news and the good news.” Plans can be shut down, altered, or frozen, changing the amount you can expect in retirement. But, investment climates also change, which means that which may be underfunded this year could be adequately funded in a few years.  

She suggests reviewing your annual benefit and funding statements for your pension plan so you can gauge its health. Anything below 80% funding is cause for concern, and even though you can’t do much about the funding of your plan, you can remind your provider that you want the benefits you were promised.  

When it comes to private plans, the benefits you have already earned are fairly protected. Companies that provide private plans can change your benefits-earning rate at any time, which can include taking it down to zero if the plan is ever frozen or terminated. The upside to this is that companies cannot touch any benefits you have already earned. Federal law protects “vested” benefits – those that you’ve earned after working a certain number of years. Companies define their own vesting guidelines, but one example may be that you have to work 5 years before you are 100% vested, or a gradual vesting schedule might mean that you are 20% vested after 2 years of service, 40% after 4, and 100% after 7.  

Unfortunately, for higher-paid employees there is a higher risk that they may not receive all of their promised pension benefits. If the plan is underfunded when it is terminated and the company can’t pay the money, the PBGC will step in, but has caps set based on age. For a 65-year-old, the cap is $4,653 per month, or just under $56,000 a year; for a 55-year-old, it is $2,094 or about $25,000 per year. The median private pension benefit was less than $8,000 in 2008, so most workers will probably get everything they have earned, but some with higher earnings may take big hits.  

In addition, most already-earned public plan benefits are also protected. While the PBGC only protects private plans, many state constitutions or other laws guard the benefits that have already been earned by public workers. Most states have trimmed benefits for new hires only in an effort to protect more vested employees. State and local governments have required workers to increase their contributions as well in order to help the underfunding problem nationwide.  

Older employees face particular risks because of the fact that, “Most pensions are designed to give extra weight to your pay in your final years of work. If your plan is frozen or terminated while you are in mid-career, you typically lose the significant boost that higher earnings in your 50s and 60s could have given you in retirement.”  

In closing, make sure you keep track of your pension plan. The Pension Rights Center says that you must keep an eye on your plan even after you leave your job. Plans can be transferred, frozen, closed, etc. on a regular basis and if you don’t keep track of them, you may end up in a bind where you have to prove you are owed benefits.

If you have any questions regarding your pension plan, or would like to discuss any other retirement planning issues, please give us a call!


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