Fewer and fewer companies offer pension plans to their employees. Of those that do, a growing number are offering lump-sum buyouts to their employees in lieu of their monthly pension.
On September 29th, former employees of 3M must decide whether to take a lump-sum payout on their pension or take a monthly pension check in the future. The decision should not be taken lightly. Depending on which way the market winds blow and what assumptions you use, this could be a $1 million decision.
Like most financial decisions, there is no clear cut answer. What's best for you may be different than what is best for your neighbor. Both decisions involve some assumptions and even a certain amount of risk. To determine if your company is making you a reasonable offer, you will need know what your monthly pension is worth in today's dollars.
What's your pension worth?
A pension is a monthly income guaranteed for life. To determine whether you should take the lump-sum offer or the monthly pension you need to know what your pension is worth in today's dollars. To do that you will need to do a "present value of an annuity calculation". Before your eyes glaze over and you face plant into your keyboard, hear me out.
Assuming that your pension payment is fixed and does not increase with inflation, the present value of your monthly pension (what it's worth today) is not as hard to calculate as it sounds. In fact, these days it's super easy. You just need to know a few variables: 1) your annual or monthly pension payment, 2) the number of years (months) you will receive payments, 3) an interest rate assumption.
With the exception of your fixed pension amount, the other two variables require some assumptions. No one knows how long they will live, but you can get an idea of how long the government thinks you might live on the social security website.
Interest rates are anyone's guess, but since a pension is guaranteed you might want to start with a return equal to that of the 30-year US Treasury bond. According to the U.S. Treasury, a 30-year bond pays about 3.2%. For a more current number, click here.
3% is a pretty low number, but considering today's interest rate environment, it's a reasonable place to start. The lower your interest rate assumption, the more your pension is worth in today's dollars.
Investopedia has a really easy-to-use present value calculator. If you are wrestling with the decision of whether to take a lump sum or a pension option, this is a good place to start. It takes about 5 seconds to enter the inputs and voila! Your present value of an annuity calculation is complete.
Once you know the present value of your pension, you are in a better position to evaluate your employer's offer to buy out your pension for a lump-sum payment. If the present value of your pension is $100,000 and they are offering you a much smaller amount, you may want to consider other options. In my experience, most of the lump-sum offers are in the general ballpark.
Lump Sum vs. Pension
Are you better off with a lump-sum today or a guaranteed monthly income for life? That's a crystal ball-type of question.
Ultimately, the decision comes down to this: do you want the security of a monthly, guaranteed income OR do you want to take control of your assets today in the hopes of providing retirement income now and passing what is left on to your beneficiaries in the future?
Tradeoffs
Every investment decision involves a tradeoff. Even so-called "guaranteed" investments have a certain amount of risk: inflation risk, default risk, etc. At a minimum you run the risk of dying earlier than expected, or that the company guaranteeing the pension fails to meet their obligations.
Below are some of the tradeoffs of taking the lump sum vs. the pension option on your retirement plan.
Lump-Sum. With the lump-sum, the primary benefit is that you control your assets and if there is any money left over at the end of your (or you and your spouse's) lifetime, it can be passed to your beneficiaries. If your investments do well, you may be able to pay yourself a monthly income for life while growing your principal -perhaps significantly. However, if your investments do poorly while you are taking income, your account value could fall to zero.
Pension. The benefit of the pension is that you get guaranteed income for life. However, when you and your spouse pass away, the pension income ends, even if you die shortly after starting your pension payments. An additional risk with pensions includes inflation. If your pension payment is fixed, it will not be able to rise to keep up with inflation in the future.
I am giving you a very simplified explanation here. Pensions can be complicated and the terms of each pension will vary from one to the next. Some may increase with inflation. Others may allow your beneficiaries to receive benefits for a minimum number of years even if you and your spouse die.
A pension can be an important part of your retirement income plan. To make an informed decision on your pension options, you will need to consider the present value of your pension, the terms of your pension payments, your risk tolerance and investment experience, as well as the needs of your spouse and other beneficiaries.
If you would like help analyzing your retirement income options, just Ask Mike.
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