Offered a pension plan payout? Do the math first!

By Jeff Bernier

If you’re lucky enough to work for a company that still offers a Defined Benefit Pension Plan—or DB pension plan—consider yourself lucky.

Unlike the more common Defined Contribution Plans, which include 401(k)s and 403(b)s, traditional corporate pension plans are quickly going the way of the dinosaur. And even among companies that are still offering DB plans to their employees, many are offering their retired employees a new type of golden handshake. Welcome to the ‘pension plan payout’—an option that allows you to forego guaranteed monthly annuity payments in exchange for a one-time, lump-sum payment of your pension.

It’s a smart move for employers, but is it really the wisest move for you? The answer is rarely simple.

Whether your past employer is defunding a plan or simply working to save administrative fees by getting retirees off their books once and for all, most companies are required by law to offer the option to remain in the plan ‘as is.’ And for many retirees, staying put and making no changes to your benefits is often the smartest choice. (Keep this in mind when you hear advisors pushing for a rollover without reviewing the trade-offs.) But in some cases, a lump-sum payout may actually be a wise option. To decide which makes the most sense for you, ‘doing the math’ is key.

Here are three examples that illustrate why the math matters*:

• When Bill left GE 16 years ago, he chose a 50% survivor annuity that would begin when he turns 65 in 2021. The option decreased his monthly distribution by about $200 a month, but provided a $1,500 monthly payout to his wife if he died. Just two years after he left GE, his wife died of cancer. Following her death, he was able to change his pension election to a single life annuity, increasing his monthly distribution amount. He thought his decision-making was done for the rest of his life. But then, two weeks ago, a payout offer arrived in the mail. Bill has a daughter and granddaughter he would like to provide for. He’s not in the best of health, and if he were to die after beginning payments, his pension would die with him. He also has significant Social Security benefits and an additional defined benefit pension from the company where he has worked for the last 15 years. The internal rate of return (assuming he lives 25 years) if he keeps the pension is around 5%. By rolling that lump sum into his existing IRA, he could take distributions to replace his current monthly pension and provide a sizable inheritance for his daughter and granddaughter. However, he would have to trade the security of guaranteed payments for the ability to leave an inheritance to his family.
• When Liz left her company, she chose a single life annuity with a guaranteed payment of $1,415 each month for life with no additional death benefit. As a widow, her primary concern was having 100% confidence that her basic expenses were covered for the rest of her life. Her former employer recently offered her a $200K lump-sum payout. When we looked at the numbers, we calculated that if she lives to be 85, she would need to earn a 7% return on those assets to replace her monthly pension income. And while that return is below the average for the S&P 500 (which has averaged close to 10% over the past 90 years), today’s environment offers lower expected returns and requires accepting significant market risks. In her case, it may not be wise to walk away from a guaranteed income with a high internal rate of return.
• When Paul retired from PepsiCo, he opted for a single life annuity that provides no death benefit for his much-younger wife, but which delivers a monthly benefit of more than $5,000. He also has a $500,000 life insurance policy (with his wife as the beneficiary) and over $1.7M in retirement savings that his wife would also receive. Based on their expenses and existing resources, Paul’s wife should have adequate financial resources. And since he’s a pretty healthy guy in his early 70s, collecting that monthly benefit adds a very comfortable addition to their regular income. For Paul, the guaranteed monthly income acts as part of the fixed-income component to his long-term portfolio, and it allows him to have more equity exposure in his investments. In the event of Paul’s death, his wife could convert some portion of her financial resources to an immediate income annuity if she wanted guaranteed payments.

Even looking at the individual factors, each of these decisions is challenging, in part because there are so many unknowns. (It’s tough to do the math when the numbers aren’t predictable!) If you, too, are facing the decision of whether or not to accept a pension payout, it’s important to begin by calculating how much you have to earn on the lump-sum amount to equal your guaranteed monthly payments. This is the “break even rate” you’d have to earn on the lump sum. To get the math as close as possible, start by answering these questions:

1. How long do I expect to live?
   No one really has the answer, but your age, overall health, lifestyle, and the longevity of your parents can help you come up with a ballpark estimate. One of the biggest arguments I hear in favor of taking the payout (even from clients who are very healthy) is, “What if I die young?” Just as with Social Security, unless that seems likely, the worst case is that you leave a smaller legacy.
2. What is the expected rate of inflation?
   The International Monetary Fund has projected that the cost of goods will rise at the rate of about 2.25% through 2024. Since monthly payments from your employer’s annuity do not typically rise with inflation, your real income is actually decreasing every year. A lump-sum payout invested in asset classes that historically beat inflation may be a way to help combat that reality.
3. What’s my internal rate of return on the pension income?
   The internal rate of return is the rate of return necessary for the investment if you take the lump-sum payout to produce the same income as the fixed monthly payment option. Of course, your life expectancy and the rate of inflation—as well as expected returns in the capital markets —all impact whether the return is reasonable.
4. What are the risks of relying on my corporate pension plan?
   There was a time when Blue Chip companies were considered untouchable and 100% reliable. That is no longer the case. Technology and global trade has disrupted nearly every industry, which means there is at least a small chance that your employer could go bankrupt and default on your plan. Pilots who worked for Delta back in 2006 when the airline terminated their pension plan were insured by the federal agency that guarantees all Defined Benefit Plans—the Pension Benefit Guaranty Corp—but they still only received about 50% of their total benefit amount. It’s a risk that is worth considering, no matter how much of a ‘sure thing’ your employer may be.

Clearly, there is no one-size-fits-all ‘best’ choice. Everyone’s situation is different, and your selection can have a huge impact on your overall benefits. A nice, fat lump sum may look and sound great, but jumping at a payout could be an expensive mistake. And while your employer can provide the data associated with each option, they won’t offer any personal financial guidance (they’re actually not allowed to by law), so it’s critical to get clear, objective guidance from an advisor you trust who is working in your best interest. Before making your selection, take a close look at your new options, do the math, and make the choice that is truly best for you and your family. We’re happy to help you figure out the details.

One last word of caution: Whatever you do, you probably should NOT take the lump sum and turn around and buy another annuity! Chances are that you’re better off with what you have now.