Americans are living longer. Life expectancy for a baby born over the last few years is 78.9 years, nearly 20 years longer than a baby born in 1930, according to the Center for Disease Control.
But longer lives raise a question: how do Americans pay for all those extra post-retirement years?
Where many employers once offered pensions, more employers have swapped out defined benefit plans like pensions for defined contribution plans like 401(k)s. Why? Because pensions put employers in a tricky situation, with unknown future costs.
If an employee retires at 62, how long will the employer have to keep paying that employee, after they cease contributing value to the company?
In many cases, the answer is “decades”. But employers simply don’t know, which means that every retired employee represents an indefinite, unknown expense for the company.
What Is De-Risking? How Does It Affect Employees?
Companies that currently offer defined benefit pension plans want more predictable expenses. After all, the more unknowns there are on a balance sheet, the harder it is for companies to budget and forecast financial planning.
Companies that still offer defined benefit plans have increasingly turned to “de-risking”. The process is simple: employers take the unknown expense of future pensions and convert it to a fixed cost.
One way employers can do that is by offering their participating employees an option to take a lump sum payout upon retirement. Alternatively, employees can choose the more traditional offer of a fixed monthly payment for the rest of their lives, which employers “de-risk” by paying a third party to assume the risks and costs.
That choice leaves employees with a complex financial choice. Should they take the lump sum payout and walk away, or the ongoing monthly pension payments?
Fortunately, the actual math is quite simple. It involves calculating what is called the “present value” of the projected benefits, and then comparing that amount to the lump sum being offered.
Comparing the Lifelong Value of Both Options
The value of the lump sum payout is greater than just the amount offered. Employees need to also include the potential returns on that money over time.
Imagine the employer offers you a choice: $180,000 lump sum payment, or $1,000/month for the rest of your life. If you invest that $180,000, what kind of income and returns will it produce for you?
One of the greatest challenges to choosing your “best option” is that you’ll need to make educated guesses and assumptions for some of the calculations.
- How long do you anticipate living?
- What kind of return on investment can you expect, on average?
Say you expect to live for another 30 years, and assume you will earn a return of 6% a year. Using the Choosing Wealth financial calculator, you can enter $180,000 as the initial investment, an annual rate of return of 6%, and a 30 year time span to calculate that you would receive $12,336.61/year, or $1,028.05/month return on the lump sum investment.
In that example, you should take the lump sum, because you’ll earn more on the monthly returns than the pension would pay you.
Another way of approaching the same calculation? You can use the Choosing Wealth financial calculator to determine that the lump sum needed to generate that $12,000/year for 30 years would be $175,088.65.
Let’s tweak the numbers for a moment, to tip the scales in the other direction. What if you only expect to earn a 5% return on your investment, not 6%? Suddenly the pension starts looking more attractive, because at 5% ROI it would take $193,692.88 to deliver the same $12,000/year in return income.
But as useful as it is to calculate and compare the expected returns of either option, the decision doesn’t just come down to dollars and cents.
Pension Risk 1: Default
Whether you take the lump sum payout or the ongoing fixed pension payments, you’ll face certain risks. One serious risk of taking the ongoing pension payments? The risk that your employer will stop paying.
Not every company in business today will still be here in 30 years. What happens if your employer goes bankrupt?
For that matter, government employees aren’t immune to bankruptcy either. Look no further than Detroit’s pension cuts.
Granted, some employers buy annuities and otherwise invest money with third parties as part of the de-risking process. But as employees decide between a one-time buyout and ongoing pension payments, there may recall the folk wisdom about the added value of a bird in the hand.
Pension Risk 2: Inflation and Cost of Living Increases
Think $1,000/month won’t take you very far in today’s economy?
Just imagine how little $1,000/month will buy you in 30 years from now.
By way of example, $1,000/month in 1988 would be the equivalent of $470/month today.
Cost of living will rise, but your pension income won’t. That means that every year that goes by, you’ll effectively get a pay cut.
Not a very promising thought, is it?
To keep the math simple above, we didn’t get into concepts like safe withdrawal rates. But one possibility with a lump sum, invested and earning a return, is that you can pull more money from it over time. After all, the fewer years you have left to live, the less money you’ll need invested.
In the early years of your retirement, perhaps you can work part time, and live off the dividends from your portfolio? The less you rely on selling off assets in the early years of your retirement, the better the chance that your portfolio will outlive you.
A fixed pension payment will effectively shrink over time. But your lump sum payout, invested carefully, will give you the flexibility to draw less in the beginning and more over time, as you need it.
Pension Risk 3: Dying Young
Retirement planning forces you to estimate how much longer you’ll live. But for most of us, that estimate is little more than a guess.
At 62, you could live for another 30 years. Or another 50 years.
Or any of us could be struck by lightning tomorrow and say our mortal farewells.
If you choose ongoing pension payments from your defined benefit provider, you get those payments for the rest of your life, whether that’s 50 days or 50 years. And then they stop.
Your children will never see a cent of your pension payments.
But if you instead choose a lump sum payout, cash the check, and then find yourself struck by lightning tomorrow? Your spouse, children, or other beneficiaries would inherit every cent of it. (Minus the government’s estate taxes, of course!)
You control your own financial future when you take a lump sum payout.
Risks of Taking a Lump Sum Payout
Opting to keep your ongoing pension payments comes with plenty of risks, as outlined above. But what are the risks of taking a lump sum pension buyout?
First, you could invest badly. Imagine you took that $180,000 and invested it all in Enron? You’d be in trouble.
Even if you invest the money shrewdly, your investments could still underperform your projections. If you ran your numbers assuming a 7% return, but only earned a 5% return, then you’ll be looking at less monthly income than you planned.
Then there’s sequence risk. It’s a lengthy topic in itself, but in essence, sequence risk is the risk that the market crashes right after you retire. When that happens, even if the annual returns over the next 30 years average the 7% that you projected, you’ll still end up with less money, because of the timing of the crash.
Why? Because you’d be pulling just as much money out of your portfolio every month during the initial crash, which means you’ll be selling low. And because you’re no longer investing new money, you won’t benefit from the recovery. The crash is all downside for you, without the upside of being able to buy at the lower prices.
Lastly, there’s the risk that you outlive your money. Pensions will keep paying you even if you live for another 50 years. But your nest egg could run dry, leaving you completely dependent on Social Security benefits.
What About Spouse or Survivor Benefits?
One curveball in the calculations is if your spouse or another named survivor would continue to receive pension benefits after you pass away.
Most common are survivor benefits of 50%, 75% and 100%. Because there are so many potential combinations if the survivor benefit is 50% or 75%, doing that calculation is beyond the scope of this article.
However, doing the comparison on the 100% survivor benefit is basically the same as doing it for the employee, but the life expectancy should take into account the life expectancy of both the participant and the named survivor.
So? Should You Take the Lump Sum or Ongoing Pension Payments?
When you take a lump sum buyout, you take control of your retirement income and financial future.
For better or worse.
If you have some knowledge and interest in investing, it can be an excellent route, assuming the math makes sense. But be sure to run the numbers with our financial calculator, because even if you love the idea of control, ongoing pension payments could still make more sense financially.
Still, control has its rewards. In an emergency, you can always tap into your investments and pull more money that month to cover the emergency costs.
And if you invest well, you can earn a higher rate of return than the (presumably conservative) assumption you used when calculating the life value of pension payouts versus a lump sum’s returns.
If the lump sum buyout makes more sense after running the numbers with our financial calculator, but you don’t know much about investing, remember that you can always hire an investment advisor or money manager.
When in doubt, ask a fiscally-minded friend to help calculate the retirement income numbers with you. Whatever you decide, you want to feel confident that after running the numbers, you made a wealthy choice!