Ford/GM
Pension
Lump Sum
Choice
Risks &
Considerations
Frank Moore, MS, CFP®
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Ford/GM Pension Lump Sum Choice
Table of Contents:
RISKS Inflation Insolvency Investments Investor BehaviorSmooth Talking Sales People CONSIDERATIONS
Your Health
Retirement Income Cash Flow Your Money Personality CONCLUSION
PROS & CONS SUMMARY RESOURCES
Disclosure: This piece was written June 7, 2012 with information available at that time. As additional information becomes available this document may be revised.
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Ford/GM Pension Lump Sum Choice
RISKS
The initial reaction of many auto employees when they learned of the pension buyout option was, “Do I want to risk my monthly pension payments on something better?” The lump sum option certainly comes with the risk of investing it wisely but there are other risks, even by keeping the monthly payments.
Inflation
The pensions of both Ford and GM offer fixed monthly payments for the rest of your life. That sort of guaranteed predictability is great, especially given the performance of the stock market over the past decade or so. Unfortunately inflation can slowly, or sometimes quickly, eat away at the purchasing power of a fixed payment.
Over the past year inflation has not been much of a problem, up just 2.3% for the year ending April 30. And even for the decade of the 2000’s it only averaged 2.5%. But over time it takes its toll. Someone retiring with a fixed pension of $3,500 per month in 2000 would have seen their purchasing power erode to just $2,704 ten years later, a reduction of about 23%.
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Sometimes inflation can be significantly higher. During the 1970’s inflation averaged over 7% and would have turned a $3,500 monthly check into just $1,611 in purchasing power by the end of the decade.
The 1966 Mustang hardtop
had an MSRP of $2,416
The 2013 Mustangs
start at $22,200
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If we look back over the past 50 years the average rate of inflation has been 4.1%. For a retiree that begins retirement at age 60 that $3,500 monthly check would only have $1,039 of purchasing power by age 90 at that long term average inflation rate.
For many people the monthly payment option will work best, but it is
certainly not without risk.
Insolvency
Another question that comes up is “How safe is my monthly pension?” In the case of Ford the first source of funds for the monthly checks is the pension plan itself. The plan, like many pension plans today, is underfunded and there is a current anticipated gap of over $15 billion1 between what is promised and what is currently funded. That gap can be dealt with in different ways but Ford is ultimately responsible for the payments.
Of course Ford could go bankrupt. In that case the Pension Benefit Guaranty
Corporation (PBGC), a US government agency, would step in to make the payments--up to a limit. Like many government agencies today, the PBGC is also in deficit ($26 billion2), but presumably the government would make good on this agency obligation.
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The PBGC limit, like most things the government gets involved with, is complicated. But let’s look at a local example. The Delphi pension plan was taken over by the PBGC in 2009. If you were a 65 year old retiree with a pension just for your life (no spousal benefit) the
maximum benefit you could continue to receive would be $4,5003 per month. If you were older the limit is higher and if you were younger the limit is lower (for a 60 year old it was only $2,925). If your benefit was under $4,500 per month then Delphi’s bankruptcy didn’t affect your regular pension check. If it was over then you’ve permanently lost the amount over $4,500 every month.
For this year the basic limit, known as the Maximum Guaranteeable Benefit, is $4,6534 per month for someone age 65. Note that while the PBGC limit may rise over time, the Delphi worker would continue to receive $4,500 per month for the rest of his life.
In GM’s case it appears that they will turn their pension obligations over to Prudential. If you opt for the monthly payments from Prudential then you need to worry about their solvency rather than GM’s. Prudential has many affiliates but most are rated AA- by Standard & Poor’s5. That’s pretty good since the US Government was dropped from AAA to AA+ last summer.
Each state has different laws regarding the insolvency of insurance companies. If Prudential were to go under the state where the Prudential affiliate is located would dictate what would happen. It’s likely that the monthly pension checks would be reduced but
probably not eliminated depending on the financial condition of Prudential at the time and the state laws.
Investments
One of the most obvious risks in taking the lump sum is the investment risk. The pension payout will likely be based on a discount rate of about 4.5%6. That means Ford is equating your monthly pension checks to the lump sum by assuming that their pension plan will earn an average investment return of 4.5% and that you will die exactly at your life
expectancy. By the way, Ford didn’t come up with the 4.5% figure, it’s dictated by the Pension Protection Act of 20067 and is based on current interest rates.
So one simple way to make the choice is to decide if you want to risk earning more than a 4.5% net investment return over the rest of your life (and your spouse). If you can then the lump sum will be more profitable. If you can’t then the monthly checks may be the way to go.
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Unfortunately today there aren’t any investment options that are as guaranteed as the monthly pension checks and that will pay more than 4.5%. At this writing the 10 year US Treasury bond yields about 1.5% and the 30 year is at about 2.5%. But, then again, US government bond yields today are at their lowest level ever.
No one knows what the future holds but let’s look to the past. If you had a portfolio that was 50% invested in government bonds and 50% in the S&P 500 stocks here’s what your returns were:
Decade Return of Balanced Portfolio*
1950’s 13.1% 1960’s 5.8% 1970’s 6.4% 1980’s 14.9% 1990’s 13.7% 2000’s 3.3% 2010-11 10.2%
* Assumes 50% invested in S&P 500 index and 50% in intermediate government bonds. Investors cannot invest directly in an index.
Over the last 62 years you could have averaged about 9.5% with a simple stock and bond portfolio. The low yields today, though, suggest that you’d earn somewhat less if you put half the portfolio in long term government bonds now.
While it would appear that earning a return equal to the historical averages would easily outpace the 4.5% that the monthly pension payments offer, there is more to investing than simply buying a couple index funds. Investor behavior has been shown to be one of the biggest investment risks.
Investor Behavior
At Vintage we’ve been counseling clients about investments and retirement planning since the 1980’s. We were there during the crash of 1987, the tech stock bubble and the more recent credit crisis. In addition to the stock market cycles we’ve seen investors lose a bundle in real estate limited partnerships, GNMA funds, flipping condos, and exciting Wall Street concoctions like auction rate securities and CDOs. Trying to earn investment returns like the indexed figures above gets complicated by human emotion and the results can be pretty ugly.
A Boston firm named DALBAR has been studying actual investor returns for nearly 30 years. They started tracking how mutual fund investors actually performed starting back in the
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early 1980’s when mutual funds became popular and 401(k) plans were first introduced. While the index returns are very good, and some mutual funds boast even better records, DALBAR has repeatedly found that actual investor returns trail far behind. Their latest results show that over the past 20 years ending in December, 2011 stock fund investors earned an average of just 3.5% despite the S&P 500 averaging 7.8%. Bond fund investors fared even worse earning just 0.9% vs. a bond index that averaged 6.5%. More balanced investors that favored asset allocation funds earned just 2.1%.
Investors that expect to earn returns near the indices and not near the average investor need to seriously consider their ability to handle investment cycles. DALBAR’s figures take into account the panic investors feel when markets drop and they sell low only to chase after bull market returns after stocks (or some other cyclical investment) return to higher levels. Working with a professional advisor that can take a more detached and analytical approach to your portfolio can be very valuable but you’ll want one that works for you, not Wall Street or some insurance company.
Smooth Talking Sales People
For metro-Detroit area financial advisors their dreams have come true in the past few weeks. Two of the state’s largest employers will release tens of billions of pension fund dollars to be directed by individuals with little investment expertise. You can bet the commission based advisors are polishing their sales pitches on their most profitable products so they can fund their own early retirement. So how can you tell if the guy in the suit has your best interests or his own at heart?
Economic incentives are pretty powerful and lead many people to do things they
wouldn’t normally do. The problem with commission based financial advisors is that they have a wide variety of investments to offer and some pay lower commissions and some pay much higher ones. If you find a financial advisor that is recommending an annuity product turn around and run, don’t just walk, out his office. These are expensive products that pay among the highest commissions and there typically are no discounts for large investments like, for instance, your pension lump sum that may total in the $100’s of thousands or even more. Many annuity products pay commissions in the 7% range so he’s got a $35,000 incentive to talk you into moving your $500,000 lump sum into his favorite product. By the way he won’t disclose that commission to you nor will you find it spelled out in the hundred page prospectus. And don’t expect him to be around to talk about how it is performing next year because he’ll get paid up front.
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Of course many financial advisors have somewhat better ethics but if their business card or website says “Securities offered through” XYZ Securities, “member FINRA” you’ll know they can earn commissions. These guys may be fun to buy a small IRA investment from but when you’re talking about one of your largest assets it’s no time to fool around. And, really, most of these guys work for firms that blew themselves up three or four years ago. Do you really want to follow their financial advice?
As we outlined in another piece, “Where to Turn for Help”, you’ll want to seek out a Fee Only CFP®. These advisors are registered with the SEC or state as Registered Investment Advisors (RIAs) and they have a legal fiduciary obligation to put your interest first. And it’s easy for them since you are the only one that pays them, not some brokerage firm, mutual fund, or insurance company.
Some RIAs work on an hourly basis but if you decide to take the lump sum you’ll want one with investment expertise that can manage your assets on an ongoing basis. Your portfolio isn’t a one time decision. The investment markets are dynamic and changes will be needed as opportunities arise.
In addition to the Fee Only RIA you’ll want someone that is also a Certified Financial Planner or CFP®. These folks are among the top 10% or so in their field and can help you sort out all the factors that go into your decision beyond just the investment part. They have additional training in investments, taxes, employee benefits, estate planning and more. These are all factors that need to be analyzed to help you make your choice.
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CONSIDERATIONS
The investment decision is very important but it’s only one factor in choosing which option to take. Your other sources of retirement income will play a big part in your choice. If you have a spouse with a pension, a significant 401(k) balance or other assets these need to be considered in your overall retirement plan. A good CFP® can help pull all the pieces together and show you how to protect against inflation, save on taxes, and meet your other financial objectives such as leaving funds for your heirs or charity.
Your Health
The monthly pension payout is based on actuarial assumptions that cover a large population of retirees, but the chances are you won’t dutifully keel over on the day they expect you to die. In fact it could be sooner. If you don’t live as long as the average life expectancy you’ll want to consider that the lump sum may leave your heirs with a portfolio balance instead of nothing since the monthly checks will cease on your death (though your spouse may be entitled to a continued benefit).
Another factor to consider is that your gender will make a difference. The pension laws require an equal monthly payout to a retiree regardless of gender. Since women tend to live longer than men the pension plan is factoring in a longer life expectancy for men than is realistic. This leads to the lump sum being somewhat more favorable for a man and the monthly checks somewhat more favorable for a woman.
You probably have a pretty good idea of your own health and the longevity in your family. Generally if you are in poor health and expect a shorter than average lifespan you’ll be better to take the lump sum. And if you expect to live a long time then the monthly payments get the edge.
Retirement Income Cash Flow
One of the most important considerations is how your retirement income looks overall. If you have other income sources the lump sum option can give you a lot of flexibility when it comes to taxes, large purchases, Roth conversions, health care needs and more.
Since both the monthly pension checks and the lump sum withdrawals are considered taxable income they will be a significant factor in your tax planning. With the lump sum you can delay or accelerate withdrawals in order to take advantage of a wide variety of tax issues. Roth conversions, medical deductions, charitable planning and the AMT (Alternative Minimum Tax) are just a few of the areas where the lump sum flexibility could save you money.
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Your Money Personality
If you are like most Americans you may find yourself at retirement with little more than a home (hopefully without a big mortgage), Social Security and your pension. If you have generally lived from paycheck to paycheck without accumulating a substantial amount of savings then you need to carefully consider how you might handle the lump sum option. Some people simply don’t have the personal attributes needed to plan for the future. Or maybe your lack of savings is due to some bad investments. Either way you may have gotten this far in life without a proven track record of providing additional funds for your future.
If so, taking the lump sum may seem like a big bonus and you can already see how you may want to spend some of it. Maybe you think paying off the mortgage would be a smart decision or that you can finally clear out the credit card balance. Before you get excited about taking the lump you need to think about how many lottery winners end up bankrupt within a few years. Your decision is much like theirs. Take the big check today or the smaller checks for years to come? Unfortunately over the next several years there will be plenty of stories about Ford and GM people that wasted their pensions in a few short years and need to survive on Social Security for the rest of their lives.
Many factors in the pension choice can be determined with some math but you’ll need to carefully consider whether your personality may be the most important one. Even if you
haven’t been able to accumulate significant additional savings you may be able to work with a professional who can advise you how to ensure that your funds may last a lifetime. If you’re likely to override their advice, though, then you may be best served with the monthly
payments. The Ford and GM pensions are generally pretty valuable assets as you can tell by the lump sum offer. You don’t want to blow that kind of money. You’ve probably worked most of your life to earn it and there won’t ever be another offer like this.
CONCLUSION
If you’ve read all the way through this piece (and didn’t skip ahead) then you can see that there are a lot of factors involved in your choice. Some are mathematical, some involve predicting the future, some depend on your personal circumstances and some on your personal abilities. If you skipped ahead to look for the easy answer it’s simply not here. There are risks in either option and you’ll need some professional advice to determine what works best for you.
In seeking that answer you don’t want to rely on friends, family or the nearest financial advisor. Find a Fee Only CFP® (or two) that can help you understand your options and how they may affect your standard of living for the rest of your life.
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VINTAGE FINANCIAL SERVICES, LLC
Our firm is available to help you analyze your choice. We’re a SEC Registered Investment Advisor, a Fee Only firm and employ the most Fee Only CFPs® of any firm in Washtenaw County. Our services include investment management, financial planning as well as income tax planning and preparation.
We offer a no charge, no obligation initial meeting and can help answer many of your questions. If you’d like a more in-depth analysis we can put together a complete financial plan that covers retirement planning, investments, insurance, taxes, estate planning and more. The fee for the plan is $500 but is waived if you become one of our clients.
For more details on our services please see our website at www.vintagefs.com or see our ADV Part 2 disclosure brochure. And feel free to contact our office with questions or to arrange a convenient time to meet. We can even make house calls.
Vintage Financial Services, LLC, 101 N. Main Street, Suite 800, Ann Arbor, MI 48104 (734) 668-4040 or (800) 666-9237
The author, Frank Moore, MS, CFP, has worked on investment and retirement planning issues with auto company employees from line workers to a CEO since the early 1980’s. He founded Vintage Financial Services in 1985 and will begin a term as President of the Midwest Board of NAPFA this summer.
Footnotes:
1 Worldwide $15.4 billion pension deficit, including $9.4 billion underfunding in its U.S. plans, Lewis W. K. Booth, vice president and chief financial officer, said in a conference call Jan. 27, according to a transcript. 2 PBGC 2011 Annual Report
3 PBGC site http://www.pbgc.gov/wr/benefits/guaranteed-benefits/maximum-guarantee.html
4 PBGC site http://www.pbgc.gov/wr/benefits/guaranteed-benefits/maximum-guarantee.html
5 Prudential ratings http://www.investor.prudential.com/phoenix.zhtml?c=129695&p=irol-ratings
6 The Pension Protection Act of 2006 requires the use of the corporate bond yields to calculate lump sum payments from defined benefit pension plans. See the current Composite Corporate Bond Rate (CCBR) at
http://www.irs.gov/retirement/article/0,,id=123229,00.html
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PROS AND CONS SUMMARY
The following summarizes some of the factors involved in your choice and which option would be best. In your own analysis some factors will have a much larger weighting in your decision than others.
Factor
Lump Sum Monthly Checks
Desire for Inflation Protection X
Not Concerned about Inflation X
Concerned about Ford/GM/Prudential/PBGC Guarantees X
Not Concerned about Guarantees X
Confident in Earning Good Investment Returns X
Not Confident in Earning Good Investment Returns X
In Good Health, Longer Life Expectancy X
In Poor Health, Shorter Life Expectancy X
Desire for Flexibility in Retirement Cash Flow X
Pension is Only Source of Retirement Income X
Ability to Take Advantage of Tax Breaks X
Desire to Leave an Inheritance or Bequest X
Male X
Female X
Able to Successfully Plan for the Future X
Typically Spend Funds as Available X
RESOURCES
Find a local Fee Only advisor at www.napfa.org Find a local CFP® at www.cfp.net/search
Pension Benefit Guaranty Corporation www.pbgc.gov
GM info on Socrates and Driving My Benefits sites and gmbenefits.com
