Selling Your Pension for a Lump Sum: A Bad Investment on Both Sides

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Retirees already have to be constantly on the lookout for criminals and scam artists trying to swindle them out of their retirement savings. But a new threat to our nest eggs has appeared: pension income streams. And while they look legitimate, they can be an expensive blunder -- and maybe illegal as well.

Pension income stream deals -- often advertised as "buyouts" or "pension sales" -- only recently began to show up on the radar screen of financial regulators, but Congress is now taking a closer look to see whether the arrangements actually break the law.

In the meantime, the Securities and Exchange Commission and the private Financial Industry Regulatory Agency issued a joint alert on pension income streams this month, urging investors considering either buying or selling them to proceed with caution.

As FINRA Senior Vice President Gerri Walsh said, "Consumers should know that a series of potential pitfalls may greet anyone who is considering selling their rights to an income stream. And any investor who is tempted by the high yield offered by buying the rights to another person's income stream should know that yield comes with high fees and considerable risks."

What Are Pension Income Streams?

The idea behind a pension income stream arrangement is simple.

Let's start with the basics. If you have a pension, you are entitled to receive monthly payments for life. As retirement benefits go, they are hard to beat: As long as you live, you'll keep getting your monthly check.

But there's a trade-off for that security: If you have immediate cash needs that exceed what you're getting from the pension, you generally can't accelerate the payout.

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Pension income streams aim to address such needs for fast cash by offering an upfront lump-sum in exchange for the right to receive future payments for a certain time period. Basically, the deal gives you an advance on your pension, then charges interest and other fees as the pension plan slowly pays it back.

For instance, if you receive $1,000 a month in pension income, a pension income stream arrangement might allow you to borrow against five years' worth of monthly payments in exchange for a lump-sum. But the amount you'll get from that initial lump-sum payment will be far less than the $60,000 that the pension will eventually repay the lender. Indeed, at least one firm pays out less than half of the total amount of the payments they'll eventually receive. Moreover, some firms charge extra set-up fees and other monthly charges that further reduce your net proceeds.

Then there's the other side of the equation: Individual investors can get in on the action by buying into these pension streams. The companies that offer these lump-sums often get capital from outside investors, promising them substantial income in exchange for upfront investments. The companies act as middlemen, paying investors less than what they receive from the pension income streams and pocketing the difference.

What's the Controversy?

Getting an advances on your pension might seem like a smart and easy way to raise cash, but it comes with huge risks both for retirees and investors.

On major reason these arrangements have attracted regulatory and congressional attention is -- as you can probably guess -- the size of the cut that the middlemen take.

If you're an investor seeing yields of 7 percent per year, you might automatically assume that buying pension income streams is a great way to earn income. But as the SEC notes, pension income streams carry high commissions of 7 percent or more, and they can be tough to sell if an investor wants to cash out early. Moreover, if the person whose income stream you buy challenges the legality of the arrangement, you as an investor could get left in the cold.

Meanwhile, from the retiree's perspective, the fees that pension income stream companies charge often equate to what would be an interest rate of 20 percent or more if the retiree simply took out a loan.

Last year, in a comment to the Consumer Financial Protection Bureau, the National Consumer Law Center found arrangements under which retirees were paying effective interest rates equivalent to as much as 106 percent. The difference between what retirees pay and the 7 percent investors get amounts to an awfully large profit for the company, which is make what is essentially a risk-free transaction.

Finally, another major concern comes from the fact that federal pension law typically disallows the sale of rights to pension payments. Although the arrangements as structured try to make a narrow legal distinction, the companies selling them operate in a regulatory gray area that makes the deals inherently uncertain.

A Checklist of Factors to Consider

Given how complex these arrangements can be, you may not even know whether or not you're getting a raw deal with a pension income stream investment arrangement. To help, consider this checklist from the SEC and FINRA:
  • If your pension or other income stream has legal prohibitions that prevent you from selling or assigning payments to someone else, then entering into a pension income stream arrangement could violate the terms of your contract or the law governing the payout.
  • The amount you receive could be a gross misrepresentation of the true value of the income stream. With interest rates as low as they are, lump-sums should be higher than many retirees might expect, so get help from an accountant or attorney to calculate a fair amount and don't accept anything less.
  • Many companies offering these streams will require you to buy life insurance, which can add a huge amount of cost to the transaction.
  • Lump-sum payments you receive in place of a stream of income could trigger immediate taxation, pushing you into a higher tax bracket and boosting your tax bill substantially.

As appealing as the chance to get a lump-sum of upfront cash might be, pension income stream arrangements are fraught with peril. You're far better off avoiding such deals if you can possibly help it. But if you decide a pension income stream deal is the only viable answer to a financial problem, make sure you address all of the items on the checklist above before you sign anything.

Best States for Retirement Aren't the Ones You Might Think
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Selling Your Pension for a Lump Sum: A Bad Investment on Both Sides
Not only does it have a Florida-like climate, but Tennessee also boasts the second lowest cost of living in the country. Combined with a low tax burden and great access to medical care, Tennessee is ideal for retirees living on fixed incomes, Kahn said. The only downside: the state has one of the country's highest crime rates.

One of the state's oldest towns, Sevierville, Tenn. (pictured above), provides close access to a national park where retirees can picnic, hike and fish, and it's an easy drive to Knoxville.
Another balmy locale, the state has an average temperature of 66.7 degrees -- behind only Hawaii and Florida for warmest average climate. Louisiana residents also enjoy low taxes, above-average access to medical care and a relatively cheap cost of living. Like Tennessee, though, it suffers from a crime rate that is among the nation's highest.

It may not be a retirement hot spot, but Bankrate says it should be. The state has the country's lowest crime rate, and an estimated state and local tax burden of just 7.6% -- lower than every state but Alaska. The downside: with an average temperature of 46 degrees over the past 30 years, it's pretty darn cold there.

For small town lovers, Aberdeen, S.D., holds a renowned film festival and has a historic downtown that plays host to farmers markets, haunted walking tours and holiday parades.

Photo: Conspiracy of Happiness,

The Bluegrass State is one of many Appalachian states to dominate Bankrate's top 10. While it may not have Florida's sunny beaches, it does boast an extremely low cost of living, warmer-than-average temperatures and a below-average crime rate.

In Louisville, retirees can stay active by walking or biking on the Louisville Loop, a pedestrian path set to eventually cover more than 100 miles. The smaller town of Danville, Ky., meanwhile, is ideal for horse lovers.

Beyond its warm weather, Mississippi also provides cheap living costs and a lower tax burden. But retirees may want to choose where they live carefully: the state has a high crime rate and subpar access to medical care. It has only 178 doctors per every 100,000 residents -- almost 100 less than the national average.

Photo: Natalie Maynor,

This coastal state came in above average for most factors that Bankrate analyzed, including climate, access to healthcare and cost of living. Its crime rate is one of the lowest in the country, with only 2,446 property and violent crimes per 100,000 people.

An affordable college town, Lynchburg, Va. offers the beauty of the foothills of the Blue Ridge Mountains, as well as historic Civil War sites.

Another Appalachian state, West Virginia is boosted onto the list by low crime, a cheaper cost of living and above-average access to medical care. Still, it has a colder climate than some of the other states.
Warm temperatures, low state and local taxes and a relatively low cost of living all pushed Alabama into the top 10. Yet it suffers from below-average access to medical care and a relatively high crime rate, with 4,026 crimes per 100,000 people -- almost double that of Virginia.

Home to a campus of the University of Alabama, Huntsville, Ala. offers botanical gardens and nature preserves and 19th century architecture. Near the Georgia border, Fort Payne, Ala. is a quintessential small town with activities that include an annual fiddling convention and a stop at the "world's largest yard sale."

Beyond its cornfields, Nebraska offers excellent access to hospital care, a below-average crime rate and living costs among the country's cheapest. But with a lower than average temperature, it's another state for retirees who don't mind the cold.
Like neighboring South Dakota, this state is not for retirees looking for warm weather. But it does have the second lowest crime rate in the nation, a mild estimated tax burden of 8.9% and 5 hospital beds available for every 1,000 residents.
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