Pension Income in Retirement, Part 1: Pros and Cons of this Increasingly Rare Benefit

Over the past several decades, public and private employers have shifted their retirement benefits from an emphasis on pensions (otherwise known as “defined benefit” plans) to focusing on “defined contribution” plans such as 401(k) and 403(b) plans. However, employees of some large corporations as well as public employees (e.g. first responders, teachers, government workers) are still entitled to pension income in retirement, and many public employees are required to pay into a pension plan from their paychecks each month. This trend away from pensions— including the option for some retirees to receive a lump sum payout in lieu of their pensions—seems motivated predominantly by a desire to reduce risk and liabilities for the employer, but it may have benefits for the employee as well. We discuss the pros and cons of pensions in Part 1 of this article (below), and we will discuss the prospects for employees expecting to receive pension income in retirement in Part 2.

Pros. The obvious benefit of a pension is the steady stream of income for retirees (and potentially their spouses) for their entire lives. It protects against longevity risk— the chance that you live longer than expected and outlive your assets. It also insulates you from market fluctuations, since the pension benefit is determined by factors external to the market (usually your salary and years of service) and the pension frees you from relying on investments for all of your retirement income.  These are significant benefits and often provide comfort for pension recipients, since they are less dependent on their investment portfolio as compared with those whose only source of income in retirement is Social Security.

Cons. As compared with saving (and potentially receiving an employer match) to a 401(k) or 403(b), however, there are some drawbacks to participating in a pension plan.

• Risks for Beneficiaries. Pension recipients generally can choose some level of survivor benefit (e.g. 50%, 75%, or 100% of the monthly pension amount) for their spouse to receive if they pass away. For this protection, retirees take a cut in their monthly benefit amount. Unless retirees choose a 100% survivor benefit (resulting in the biggest cut to their monthly benefit), their spouse still faces some risk of lost income in the case of death. Additionally, if the retiree is single when he or she passes away, or if both spouses pass away in close succession, the pension asset disappears completely without any further benefit to the recipient’s heirs. By contrast, retirement plan assets pass in full to one’s spouse or to one’s heirs.
• Inflexibility of Income. The down side of the “steady stream of pension income” is you cannot choose the timing on when to receive it. With retirement plan assets, you can choose to withdraw more or less in a given year, depending on your needs. With pension income, there is no way to reduce current benefits (e.g. for tax purposes) or to draw on future benefits (unless you borrow funds and use the pension to pay off the debt). For instance, you cannot access more of your pension asset to pay for unexpected medical costs, a child’s wedding, or other lump sum expenses.
• Lack of Investment Control. The dollars that you contribute toward your pension while working are invested in a pension fund, and you do not have control over how those dollars are invested. Your employer is responsible for managing the fund to meet its obligations, though not all employers are on track to do so (see below). Additionally, you do not derive any benefit from positive swings in the market. By comparison, with a retirement plan, you may be exposed to downturns in the market, but there is no limit on the upside potential of how your investments might grow.
• Inflation Risk. While most public pensions include annual cost of living increases, the benefit amount for private pensions generally stays flat over time. Inflation therefore diminishes the purchasing power of your pension income with each passing year.

Thus, while the promise of pension income does tend to give retirees a sense of security as they enter retirement, there are some drawbacks to that asset as compared with retirement plan savings. If you are eligible for a pension and face pension-related decisions, please contact us so that we can help you weigh the pros and cons for your specific circumstances.