What’s more appealing: A steady paycheck for the rest of your life, or a one-time payout to use as you please?
Weighing these choices isn’t just the stuff of daydreams. For the lucky few entitled to a pension from a private sector job, the paycheck versus lump sum dilemma is real—and increasingly common.
Over the past few years, a growing number of company pension plans have asked vested employees to choose between their pensions or a buyout. (Companies aren’t allowed to offer buyouts to retirees who are already collecting benefits.) We don’t have clear statistics on how common such offers are, but the Government Accountability Office says the uptick started in 2012.1 Why? Regulatory changes that tend to make buyouts a lower-cost option for companies are a big reason. (For more on this, see “Why offer a buyout?” below.)
But if buyouts are better for companies’ bottom lines, what do they mean for the people who accept them? As with most aspects of retirement planning, that depends on the individual.
“Before deciding between a pension and lump sum buyout, you need to determine what role that steady income stream might play in your overall retirement plan,” says Nancy Murphy, a Senior Financial Planner with Schwab Private Client (SPC) based in Indianapolis. “Ask yourself: How close are you to your retirement goals? What other income sources do have? And what are your spending needs?”
It’s a lot to consider. On one hand, knowing that you and in some cases your spouse will get a check each month for the rest of your lives is comforting. On the other, getting a large sum of money to invest can be tempting.
Here we’ll discuss some of the pros and cons of each choice.
The chief attraction of a pension is the monthly lifetime income. In general, the value is set according to a formula laid out by the plan provider. For example, it might be based on your salary, years of service or some combination of factors.
It could also include a survivor benefit entitling your spouse to a monthly payment if you die. Signing up for a survivor benefit will mean a smaller monthly benefit to make up for the fact that payments to your spouse will continue after you’re gone. Survivor benefits can vary, but the norm is 50% of the original benefit. In other words, a single retiree might receive $4,500 a month, while a couple might receive $3,700, with a survivor benefit of $1,850.
Private pension plans are also backed by a federal agency called the Pension Benefit Guaranty Corporation (PBGC) that will cover your monthly payments up to a set amount if your employer goes bankrupt. According to the PBGC, a single 70-year-old could receive up to $8,318.86 a month if his or her employer goes out of business in 2016 (or $7,486.97 for a plan with a 50% survivor benefit).
Company bankruptcy is just one of the potential downsides of keeping a pension. Here are a few others:
- Pension payments are usually fixed, so you don’t get any protection against inflation. Even if inflation is low, the value of your monthly benefit will shrink over time. For example, if prices rise 2% a year for 20 years, the purchasing power of a $4,500 monthly benefit will be cut by about a third during that time period.
- You can’t liquidate your pension if you suddenly have a large expense. If you have an unexpected medical bill, for example, you’ll have to tap your savings or other sources.
- You can’t include a pension in your estate. Even with a survivor benefit, payments end once both spouses are no longer living.
Lump sum buyouts
The main appeal of a buyout is flexibility. With cash in hand, you have the opportunity to invest it for growth by rolling it into an IRA (you could also take the cash, but that could mean a big tax hit). You have full control over the investment strategy, and could potentially leave some of it behind as part of your estate.
Buyout sizes vary. The government has guidelines for the formulas companies can use to calculate offers, but there aren’t any hard-and-fast rules. The formulas are also complicated. In broad terms, lump sum values are based on a combination of interest rates and life-expectancy calculations set by the IRS.
After all, a lump sum is essentially an estimate of the present value of a lifetime’s worth of benefits. For example, a pension plan could ask a 70-year-old to choose between a $4,500 monthly pension or a lump sum payment of $600,000.
The major potential drawback of taking a lump sum is the possibility that it’ll run out. If you choose to invest the money, you’ll be exposed to investing risks. If you suffer large losses, that lump sum may not be enough to see you and your spouse through to the end of retirement.
You will also be giving up the possibility of a survivor benefit. In fact, your spouse will have to sign off on a decision to take a lump sum.
How to choose
Again, how you decide depends on your overall financial picture and longevity expectations. If you expect to have large recurring expenses and think you and your spouse will live long lives, a pension might look more attractive. If you have a large amount of savings or high immediate costs, or are in poor health, then a lump sum might start to look better.
There are also some more complex financial considerations that can pop up, so it makes sense to speak with a financial professional before deciding.
When Financial Consultants work with a client in this situation, they start by seeing how a pension fits in with the client’s overall savings and expenses. And then they might set up a meeting with a Financial Planner from SPC’s Wealth Strategies Group who can help dig deeper into what other issues they should consider. “Buyout offers are unique, and the details matter,” Nancy says. “For example, it helps to look at the different break-even points, in which you see what sort of investment returns you’d have to earn to match an income stream that might last for decades.”
In addition, Financial Planners can help look at how the pension decision might impact other concerns, such as estate planning. The most important thing is not to rush into a decision. Once you decide there’s no going back.
“The window you have to make a decision about taking a lump sum is pretty small,” Nancy says. “Make sure you have enough time to review the terms. You don’t want to make the decision two days before the window closes. That’s not when you do your best thinking.”
Want to know more?
Call your Schwab consultant or 800-355-2162 to discuss your retirement plans and pension considerations.
1 Government Accountability Office, “Private Pensions: Participants Need Better Information When Offered Lump Sums That Replace Their Lifetime Benefits,” 1/2015.
Why offer a buyout?
Companies that offer pensions may be looking for ways to cut their ongoing costs. Continuing to pay employees after they stop working can be expensive, especially with people living longer. At the same time, low interest rates have made it difficult for pension plans to earn enough returns to cover their obligations. Moving people out of pension plans through buyouts reduces the burden.
A few other factors are making lump sum offers more attractive to companies now:
- A rule change in 2012 made buyouts cheaper. Pension plans are now allowed to assume higher future returns on their investments. As a result, they can set aside smaller amounts in the present to cover future benefits. That means lower lump sum calculations.
- Rising interest rates also mean smaller lump sums. Again, this has to do with the return assumptions used to calculate the size of payouts. Higher interest rates mean companies can offer lower lump sums.
- Pensions will grow more costly when the IRS adopts longer life-expectancy estimates in 2017. Pension plans will have to set aside more money to account for longer lifespans. Getting people to accept buyouts now will help companies avoid the extra cost—and will be cheaper than offering buyouts based on the new lifespan estimates.
- PBGC premiums are rising. This increase is making pensions more expensive to operate and may be another reason companies are encouraging lump sum payouts.