Taking your pension as a lump sum? It comes with risks

This is the longer version of the blog I wrote for the Wall Street Journal, which is posted here: http://blogs.wsj.com/experts/2015/06/11/the-pension-payout-lump-sum-or-annuity/

As employers continue shifting pension responsibilities to workers, a new question has surfaced: Should employees take their pensions as annuities or lump sums? Workers with defined contribution pensions will have to decide this, and employees with defined benefit pensions are increasingly given this choice too, as firms try, for example, to reduce oversized plan liabilities.

Managing one’s pension can bring opportunities, but it also comes with risks. Indeed, the very reason for offering a lump sum is to transfer the risks from the pension plan sponsor to the individual. There are several issues to consider when such option is on the table.

Financial markets: An individual who opts for a lump sum must then manage that money. If investing in financial markets, the individual must decide how much risk to take. Even if the money is tucked under the mattress (figuratively), there is inflation risk—the risk that rising prices will dilute the money’s purchasing power.

Longevity: If a pension is taken as a lump sum, it still must last a lifetime. Individuals can buy annuities in the retail market, and there is a notion that there may be more and better choices in the market than what is offered by a single plan sponsor. However, as the January 2015 report of the Government Accountability Office (GAO) [“Private Pensions/ Participants Need Better Information When Offered Lump Sums that Replace their Lifetime Benefits”] emphasized, retail market annuities are likely to be more expensive than group annuities.

Protection: The Employee Retirement Income Security Act of 1974 (ERISA) established protection for pension plan participants and their beneficiaries. For example, ERISA set minimum funding standards for pension plans that are sponsored by private employers. And the Pension Benefit Guaranty Corporation (also established by ERISA) acts as the insurer of private sector defined benefit pension plans by guaranteeing participants’ benefits up to a certain statutory limit. The protection ERISA offers to defined benefit pensions is lost when pensions are taken as a lump sum.

Whether to take a lump sum payment is not an easy decision. One of the greatest risks is perhaps the failure to understand the risks involved. When I testified about this issue before the ERISA Advisory Council on May 28, 2015, I discussed the empirical evidence we have about financial literacy and how little people know about risk and how to manage risk. This is why it is so important to provide not just information but also tools that make it easier for individuals to tackle this decision. One such tool is a calculator that shows how different interest rates and mortality tables translate into different lump sum payments.

Lump sum payments can sound attractive, and for some workers they may be better than annuities, but this is a serious decision that requires careful thought, clear planning and an understanding of how markets work.