Reuters Money

Bob worked as a firefighter in Arizona until last September, when he was determined unfit to work for medical fitness reasons.

Like most public sector workers, Bob (not his real name) participates in a traditional defined benefit pension plan, this one sponsored by the state’s Public Safety Personnel Retirement System and he’s applied for early medical-related retirement. But he worries about the future reliability of the pension fund.

“My concerns are that since the Arizona state retirement system is only 68 percent funded, and seeing the backlash in the country toward public retirements, I wonder if I should consider taking a lump sum? The lump sum would be $110,000, or I could receive a monthly annuity of $2,000.”

Bob posed his question after I wrote in December that taking a lump sum at retirement is often a bad deal for private sector workers. Most private sector workers take a lump sum, succumbing to a “it’s my money” mindset. Yet most often, they would get more in lifetime payments from an annuity-style pension. And the guaranteed income stream provides valuable insurance against longevity risk –- that is, the risk of outliving your money.

But what about the public sector?

Most government workers still participate in defined benefit pension plans — unlike the private sector, where they’ve become a disappearing breed. Yet state and municipal employees approaching retirement are worried by headlines about rising levels of unfunded pension liabilities.

There’s even been chatter in Washington about a Republican-led charge to revise federal law to allow states to file for bankruptcy to cope with rising debt and pension obligations. While it’s not likely to happen so long as Democrats control the U.S. Senate and White House, allowing bankruptcy could set the stage for states to rip up union agreements and unilaterally reduce benefits — not to mention setting off havoc in the municipal bond market.

What does the unsettled environment mean for government workers facing the choice of an annuity or lump sum at retirement?

First, pay attention to the fiscal health of your plan –- not to the headlines about what’s going on around the country. While plans are operated by both states and municipalities, 89 percent of active public sector participants are in state-sponsored plans, according to the Center for Retirement Research (CRR) at Boston College –- and their health varies widely. Some states have kept up on annual required contributions, while others relied on the long bull market as a substitute for contributions during the past two decades.

Further, understand that the funded ratio refers to a plan’s ability to meet pension obligations over a 30-year period — not tomorrow.

The result is wide variation in funded ratios. Illinois, California and New Jersey are poster children for underfunding, while Florida, Georgia and Massachusetts are over-funded, according to research by CRR (see chart).

Further, funding ratio gaps vary dramatically depending on assumptions used to project future portfolio returns. Economists and policymakers are having a healthy debate about this. Most systems use an eight percent assumption, which is endorsed by the Governmental Accounting Standards Board; some economists prefer a more conservative “riskless rate” of about five percent, arguing that the pension obligations are guaranteed and therefore should be weighted heavily toward the least risky portfolio investments, typically Treasury bonds.

Under-funded state-run pension plans likely will see changes in plan design, such as higher retirement ages for workers outside of public safety jobs, and shifts to 401(k)-style defined contribution systems. But such changes will impact mainly younger workers and new hires who are years from retirement. For workers close to retirement age, taking a lump sum rarely is the best move. Here’s why:

The problems are overstated. The headlines about unfunded liabilities confuse cyclical economics with the way pension plans actually work. “The idea that there is this huge crisis and states will start defaulting on debt payments or won’t make pension payments is over-blown,” argues Elizabeth McNichol, a senior fellow at the Center on Budget Planning and Priorities (CBPP) who specializes in state fiscal issues. “People are taking current fiscal problems caused by the recession’s impact on state revenues and adding in an exaggerated view of the debt and unpaid pension obligations. That makes the problems seem much larger than they are.”

McNichol is co-author of a recent CBPP report arguing that the cyclical problems of state and municipal pension funds will ease as the economy improves.

The promise is strong. “Public pensions are a contract protected by law,” says Andy Peterson, a specialist on retirement systems at the Society of Actuaries. “For the most part, once an employee is hired under a certain benefit plan, you can’t take that away, even for future service. That’s very different than the private sector, where the law protects benefits earned to date but employers can make changes to benefits earned in the future.”

“In the public sector, you can only change benefits for new hires, and that’s being done in a lot of places now. But from a [current] employee perspective, the guarantee is fairly strong.”

You may be walking away from employer contributions. Most public sector workers are required to make substantial contributions to their plans from salary. But in many cases, workers who take lump sums at retirement walk away only with their own contributions –- not the employer contribution or accrued interest. “Usually, you short-change yourself because it’s only a minority of cases where you are entitled to the employer contribution with a lump sum distribution, ” says Keith Brainard, research director for the National Association of State Retirement Administrators.

Replicating the lifetime income stream is difficult.“The question is, what would it cost to replace that pension with an immediate annuity?” says Charles Bennett Sachs, a financial planner and principal with Evensky & Katz Wealth Management. Bennett Sachs did the math for a client who teaches in the Miami-Dade County teacher in Florida who plans to retire a year from now.

She can choose between a monthly annuity-style pension payment of $3,283 with a three percent annual cost-of-living adjustment (COLA), or a lump sum of $540,000. The cost to replace that monthly income with a single premium income annuity with that same three percent COLA: $875,000.