Evaluating a Pension Buyout

Brian Burton

Key Takeaways:

 

  • Calculating the “hurdle rate” of return is an important first step in determining whether staying in the pension or taking a lump sum is the best option for you. 
  • Beyond the math, there are other big-picture variables that should be considered before making a decision. 
  • The pension vs. lump sum decision should be made in the scope of a full financial plan with all of your unique circumstances factored in.

 

Those entering the workforce today will most likely never feel the security offered by a pension plan like many of their parents and grandparents have.  As defined contribution plans such as 401(k)’s took centerstage in the late 1980s, the use of defined benefit plans as an employee benefit quickly became a thing of the past.  However, for today’s workers approaching retirement, many are active in pension plans and may soon face a challenging decision of whether to keep the lifetime stream of payments or choose a lump sum instead.

 

The first step of the decision-making process is to fully understand the terms of a buyout.  Most often, buyouts come in the form of a lump sum distribution that represents the present value of an employee’s future pension payments.

 

If you are one of the lucky one’s eligible for a pension at retirement, you should become very familiar with the term “hurdle rate” as it is one of the most important factors in deciding whether to take the lump sum or receive fixed monthly payments.  The hurdle rate is the rate of return necessary on the lump sum investment to produce the same income as the monthly payment option.  Here is an example of how this calculation works:

 

Kim is looking to retire in the next few months at age 65.  She has the option of a single-life pension of $75,000/year or a lump sum of $900,000.  Let’s assume Kim will live to her life expectancy of 85.  She would receive 20 payments of $75,000 over the course of 20 years adding up to a total of $1,500,000.  After calculating the internal rate of return, we learn that if Kim takes the lump sum and invests it for the remainder of her life (20 years), she would need to earn a 5.46% annual return to produce the same $75,000 of income the pension offers.  If we assume Kim’s life is extended another five years to age 90, she will need to earn 6.68% on her investments.

 

As you can see, a huge variable in determining the hurdle rate is life expectancy, as the longer you expect to live, the higher the required return will be, and vice versa.  Also, keep in mind these offers are typically based on actuarial charts and assumptions on investment returns for a lump sum payout, and are most often structured in the favor of the company offering them.  That’s not to say a buyout is more often the lesser option; there is a softer science, qualitative piece to the decision beyond just the mathematical side.

 

Here are a few of the big-picture variables that should be considered along with what the math tells us:

 

Individual Goals for the Money – Are you concerned more about income generation or leaving a legacy for children or grandchildren?  If the focus is on income, the better option may be staying in the pension.  On the other hand, someone driven to leave a legacy may benefit more from a lump sum because of the control offered.

 

Behavioral Tendencies – One of the biggest benefits of sticking with the pension is the elimination of longevity risk (assuming the pension plan remains solvent), meaning there is no concern about outliving the money, no matter how long you live.  With the lump sum option, the risk of blowing through the money can be a real concern, particularly for those that struggle with overspending habits.

 

Risk Tolerance – To achieve the necessary hurdle rate, particularly in a low interest rate environment, investors of a lump sum will most likely need to own risk assets which may have major fluctuations in value.  If you opt for the buyout, will you have the discipline and risk appetite required to keep your money invested through volatile market cycles?

 

Financial Stability of the Employer – Is the company that you are depending on for the next 20, 30, or 40 years in good financial health?  Many of today’s private pension plans are underfunded, do you know if your plan is well funded?  These answers could have a major impact on your decision to stick with the plan or take the buyout.

 

For those retirees or soon-to-be retirees who are eligible for a pension, the lump sum or annuity decision can be equal parts complicated and emotional, as the outcome will likely permanently impact your financial situation.  Keep in mind, these decisions should ideally be made in the scope of a full financial plan with all of your unique circumstances factored in.  The decision that’s right for one person may not be best for another and the wrong choice could prove detrimental.

Atheneum