Deciding to take a lump sum instead of ongoing pension payments is challenging. One option gives you a nice big check with all the associated possibilities and the other option promises years of much smaller monthly checks. Which should you choose? Is there one right answer?
Unfortunately, there’s no one-size-fits-all answer to this question. I have my professional biases and I’ll get to those in a moment. But as with most things financial it’s a facts-and-circumstances sort of issue and your “right” answer can absolutely be different from your coworker who was offered roughly similar terms.
During my time as a financial planner I’ve encountered this question hundreds of times. While the circumstances are often different, there are commonalities that help create a rough framework for how to think about these questions for yourself.
Along these lines I’m including portions of a recent WSJ article on this topic. The author gives her perspective after being offered an early pension buyout by her employer. Her approach is probably the most straightforward I’ve read, so that’s why I’m sharing it with you.
But first I’ll add some of my own thoughts.
Much of the decision process associated with this is emotional and that’s okay. Someone is offering you what seems like more today all at once when the alternative is waiting to receive what seems like less over time. Apparently this is why nearly half of people who are offered pension buyouts decide to take them.
The main problem with this is a lack of appreciation for how time value of money and the present value concept works. In finance, present value implies that money received today is worth more than the same amount received in the future. That seems straightforward so maybe that’s where many people stop. However, money received within a pension framework isn’t the same now or later because it gets adjusted for an assumed rate of return, inflation, or perhaps the yield on a government bond benchmark. This adjustment is meant to equalize the difference between now versus later.
The pension program guarantees your income based on how long they think you and other pensioners will live and how much they expect to make on plan assets along the way. It’s easier for them to simply cut you a check because then they’ll no longer be responsible for providing your income. They back out their assumed rate of return, which is higher these days as government bond yields have risen and mail you your check assuming that you’ll take the ball and run with it. Doing so takes a bite from plan assets but saves money in the long-term as the future value of those would-be payments is higher than the present value check you just cashed, assuming the pension managers invest prudently over time. Who benefits from these potentially higher future values? The retirees who opted to keep their pension.
Assuming you take the lump sum buyout, you’ll want to at least replicate the pension program’s assumed rate of return to come out even over time. If not, you've lost money. If you put your lump sum into an IRA, such as the WSJ reporter says she’ll do with hers, you’ll be taking all the responsibility of being able to pay yourself at least as much as the pension program would have. I don’t have any numbers to back this up, but I’ll wager that most people who take the lump sum and manage things on their own don’t accomplish this.
Because of this over the years I’ve recommended that clients choose the lump sum option less than 10% of the time. I know that most people prefer the sense of security that comes from receiving regular income. I also like them to worry a little less about how their investments are doing. And pension plans usually have lots of participants and assets, so risk is spread around versus the retiree going it alone in their IRA. (Obviously I can and do help manage these dollars for clients, but you see my point…)
So, if it’s “extra” money maybe go ahead and put it in your IRA, invest aggressively and grow it for somebody else, such as your kids or other beneficiaries. If that investment risk scares you or if you’re planning, perhaps ironically, to use the money for long-term income, you’re probably better off leaving the risk on the pension plan’s shoulders.
That said, there are a variety of reasons why taking the lump sum might be an option. Maybe you have other savings and investments to rely on. Maybe you have additional income beyond Social Security, such as rental income, royalties, or all that cash coming in from your encore career as an Instagram influencer. Maybe you have reason to be very concerned about the health of the pension program and it’s not insured by the PBGC (https://www.pbgc.gov/about). Or maybe you favor independence (as I do) and have other plans for the money, bearing in mind that it’s likely all taxable as you withdraw it.
From the Wall Street Journal (a link is below if you’d like to read the entire article)…
A few weeks ago, my former employer offered me a check for nearly $44,000. If I take it, I’ll have to give up a monthly pension of $423, scheduled to start at age 65.
Should I grab the $44,000—or keep the pension?
Deciding whether to take the money or keep the pension requires doing some math and weighing competing risks. Taking an upfront payment—as more than 40% of workers typically do—raises the odds you’ll run out of money in old age. But many workers have pension incomes that lack cost-of-living increases, leaving them vulnerable to inflation…
…Despite significant reservations, I’m taking the upfront money this time. That doesn’t mean you should do the same. Here’s what to consider:
Crunch the numbers
The math frequently favors keeping the pension, said Joshua Gotbaum, former director of the U.S. Pension Benefit Guaranty Corp., or PBGC, which insures benefits when companies terminate pension plans and lack the assets to cover promised payments.
To replicate my pension, I asked New York Life how much it would cost me to buy a deferred annuity that will pay me $423 a month, starting at 65. The answer: $55,531, which means my payout falls $11,531 short of what I’d need.
I could instead invest the money.
Assuming I were to earn the S&P 500’s long-term average annual return of 7.4%, my $44,000 would appreciate to $72,500 by the time I turn 65. Using the 4% withdrawal rate that long has been considered a relatively safe level of retirement spending yields an initial monthly withdrawal of $242. With 3% annual inflation adjustments, that wouldn’t grow to $423 until I am about 84.
Reasons to keep the pension
Longevity is the main reason I kept my pension in 2015. The longer I expect to live, the more valuable my pension’s promise of a lifelong income.
Steve Vernon, a former pension actuary, advises people to keep a pension if they lack enough guaranteed income from other sources, including Social Security, to cover such basic expenses as food and housing.
A pension also makes sense for those who aren’t comfortable managing their money or might have difficulty doing so in their later years, Vernon added.
My pension is small enough that in the unlikely event my former employer falls on hard times and turns its pension over to the PBGC, my payment should be fully covered. (The PBGC currently insures up to $6,750 a month for a 65-year-old.)
Why I took it
I’m going to take the $44,000 and roll it into an IRA, where it can grow tax-deferred until I start taking required annual distributions at 75.
Why the change of heart?
As retirement approaches, I have a better understanding of our future finances, including other guaranteed sources of income.
Inflation also spooked me. My $423 monthly check seemed substantial enough back in 2015. But thanks to rising prices, I’d need $544 to have the same buying power today. Because my pension is frozen at $423 a month, it is going to buy even less when I’m 65, never mind 85. Having a guaranteed income stream that covers an ever-shrinking share of my future budget doesn’t seem that helpful.
I hate to admit it, but my decision is also an emotional one. When I consider what my 2015 lump-sum would have grown to had I invested it in the stock market, it is hard not to feel regret. Since Jan. 1, 2016, the S&P 500 has earned a 12.25% annualized return.
To find out how much I’d need to earn on the money to match the promised pension income, I called Brian Tegtmeyer, an adviser in Dublin, Ohio.
He said if I live to 85, I’d need to earn an average of 5.9% a year on my $44,000 to equal the cumulative income from my pension, assuming I invest my monthly checks and earn the same 5.9% return. If I reach 90, my lump-sum would have to earn 6.6% a year to equal the pension. At 95, the break-even return would be nearly 7%.
Because I’d have to take a lot of investing risk to keep up with the pension, Tegtmeyer recommends sticking with the pension.
But I have a high risk tolerance and I figure 6% to 7% isn’t an unrealistic average annual return to expect over several decades. So I’m going to invest the money and hope something remains for my sons, who aren’t eligible to inherit my $423 pension.
Here’s the link I mentioned… WSJ has a paywall so let me know if you hit it and I can send this to you from my own account.
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