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.
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.