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Mark Miller: Remaking Retirement

Safeguard Your Pension Benefits in Retirement

Morningstar columnist Mark Miller questions how much you can rely on your pension to be there when retirement rolls around.

Pick up a newspaper, and there's a good chance you'll find bad news about the traditional U.S. pension.

The most recent unsettling story came in February, when American Airlines proposed termination of four pension plans covering 130,000 workers as part of its bankruptcy proceedings. The airline later backed down from the plan--which would have marked the largest default of a defined-benefit plan in U.S. history--saying it will seek court permission only to freeze all its plans, with the exception of the one covering its pilots.

Meanwhile, public-sector pension plans have come under political fire in many states, where concerns have mounted about unfunded liabilities and the ability of taxpayers to keep funding the retirements of government workers.

But despite the gloomy headlines, defined-benefit pensions are far from extinct. In the public sector, 87% of workers still have access to a traditional pension plan, according to the U.S. Bureau of Labor Statistics. Additionally, 35% of Fortune 1000 companies still sponsor actively accruing pension plans, though that figure is down sharply from 59% as recently as 2004, according to employee benefits consulting firm Towers Watson. In most cases, companies that froze defined-benefit 
plans replaced them with defined-contribution 401(k) plans, which limit employers' long-term exposure to funding worker retirements.

If you have a defined-benefit pension, count yourself fortunate. Along with Social Security, a traditional pension is one of the best sources of lifetime retirement income you can have--and it can be a critical source of protection against longevity risk--the risk of outliving your resources in retirement.

But can you rely on your pension to be there when retirement rolls around? And what practical steps should you take to safeguard your benefits?

Pension Health Today
Funding levels of both public- and private-sector pension plans have been hurt by the current ultralow interest-rate environment, which makes it difficult to earn adequate returns on portfolios.

In the private sector, the aggregate funding level of corporate pension plans at S&P 1500 companies stood at 79% at the end of February, according to Mercer.

The Pension Protection Act of 2006 required plan sponsors to get their plans to fully funded status over a period of years, but Congress has granted waivers and extensions several times in recognition of the difficult economic and investment environment. Even now, action is pending in Washington on a corporate pension-relief measure that would allow plans to reduce short-term contributions.  

In the public sector, pension plan funding in some states has fallen to worrisome levels. One frequently cited example of a basket-case system is Illinois, which failed to make the necessary plan contributions for years and had a funded ratio of 43.4% as of June 30, 2011.

But nationally, the story is more positive. Aggregate asset/liability ratios have been rising. The funding level for all state plans combined was 77% last year, up from 69% in 2010, according to Wilshire Consulting. The gains stemmed from strong stock market performance in the first half of 2011, and growth in fund assets outpaced growth in plan liabilities.

However, these measures of long-range pension plan health depend heavily on the rate-of-return assumptions used by plan administrators. This has been an especially contentious issue in the public sector, where most pension plans assume a long-term rate of return around 8%, reflecting a portfolio invested in equities, bonds, and alternative assets such as hedge funds. That assumption--backed by many actuaries--is supported by actual investment history. At the end of 2010, public funds reported an aggregate 25-year rate of return of 8.8%.

The flip side of this argument--generally supported by economists--is that much more conservative rate-of-return assumptions should be used because if returns fall short, taxpayers are on the hook to make up the difference. That argues for using a "riskless rate of return" assumption reflecting what a fund could earn on Treasuries or corporate bonds.

The two approaches to rate of return produce staggering differences in funded ratio projections. One advocate of riskless-rate projections, economist Joshua Rauh of the Kellogg School of Management at Northwestern University says the riskless-rate method pegs aggregate unfunded liabilities of state and local governments at about $4 trillion. Assuming a long-range 8% rate of return gets you to a much smaller figure--roughly $3 trillion less.

Measuring Your Plan's Health
In the private sector, your plan's funded status is one indicator of health--and you can find that number in the funding notice that your employer is required by law to send to you annually. Just as important, pay attention to what's going on in your industry. Because employers worry about providing competitive benefit packages, they're less likely to abandon a defined-benefit pension plan if they're offered by competitors.

Beyond that, it's important to play good defense. Keep thorough records of your employment history and all correspondence, notices, and documents relating to the retirement plan and your benefits. Read and save summary plan descriptions, and verify the accuracy of individual benefit statements that you receive. If you need help with that, contact one of the free legal counseling services available through the U.S. Administration on Aging's network of Pension Counseling and Information Projects.

If you participate in a corporate defined-benefit plan that is frozen, your employer would continue to manage the plan and is obliged to pay out benefits at the level promised at the time of the freeze. However, you won't accrue any further benefits, and new employees wouldn't participate.

American Airlines initially proposed what's called a "distressed" plan termination. In these situations, pension plans are taken over by the Pension Benefit Guarantee Corp, or PBGC, the government-sponsored agency that insures most private-sector defined-benefit pensions. The PBGC is funded through insurance premiums paid by plan sponsors. 

In a distressed termination, the PBGC takes over the plan's assets and liabilities as well as responsibility for paying benefits. But in other, so-called standard terminations, an employer demonstrates that it has sufficient assets to terminate the plan by purchasing an annuity for each plan participant or by paying a lump sum, subject to the plan's rules.

When the PBGC does take over a plan, workers generally receive 100% of what they earned, but only up to the point of the plan's termination. That can mean significant benefit losses in retirement, and it's especially damaging for older workers who are at their peak earning power because they won't accrue benefit credits for their last working years. All workers become 100% vested at the point of termination and transfer to the PBGC.

Moreover, PBGC payouts are capped by law, and generally they won't amount to full coverage for the highest-earning workers, such as airline pilots. The cap is determined using a formula based on your age at the time the plan is terminated, and it is updated every calendar year. For 2012, the maximum monthly benefit for workers retiring at age 65 is $4,653.41, or $4,188.07 if you elect a joint and survivor option that pays benefits to a spouse. (If you participate in a multiemployer pension plan, guarantees are much lower because of differences in the insurance plan design and premium levels. Currently, it's set at $1,072 per month.)

Lump Sum or Annuitized Payments?
Many pension plans offer the option at retirement of taking benefits as a series of regular lifetime payments or as a single lump sum. Worries about pension health tempt many workers to take the lump sum, but think twice before picking this option.

Although there's no one-size-fits-all answer, most retirees will come out ahead over the long haul by taking their pension as an annuity. A key reason: annuity-style pension benefits offer valuable longevity-risk protection at a very low expense that is impossible to replicate on your own.

Moreover, the formulas used to calculate lump sums aren't favorable to workers. Private plans calculate lump sums using longevity and interest-rate factors, aiming to match the amount that a pensioner would need to invest to match annuitized payments. In that sense, the choice between lump sum and annuity theoretically should be neutral, producing the same result over time.

But in practice, it doesn't work out that way.

A key reason is a change in lump-sum calculations mandated under the Pension Protection Act of 2006. The revision--which was sought by plan sponsors--changed the benchmark interest rate used to calculate lump sums. They argued that lump-sum payments--which move inverse to interest rates--were being inflated artificially by ultralow 30-year Treasury rates. The PPA replaced the Treasury rate with a higher composite corporate bond rate that has been phased in fully as of this year. The corporate rate is a little more than 100 basis points higher than the Treasury rate.

In the case of public-sector plans, retirees could be walking away from employer contributions. Most public-sector workers are required to make substantial contributions to their plans from salary. However, in many cases, workers who take lump sums at retirement walk away only with their own contributions--not the employer contribution or accrued interest.

Click to read Part 2 of this article series: investors' options for pension replacement, and policy ideas on the horizon for reducing risk and boosting retirement income.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.