Once upon a time, many employers offered pension plans to employees. Pensions are financial vehicles designed to replace a portion of the employee’s wages during their retirement years, providing them a reliable income for the rest of their life.
Nowadays, pensions have fallen out of favor among many employers due to the maintenance costs, increased longevity, and compliance obligations. Because of this, many employers are seeking to buy people out of their pension benefits, either with a lump sum or different lifetime income benefits.
If you’re in a position where an employer is offering to buy you out, it’s critical to learn how to assess different pension buyout options.
Purpose
Because pensions are meant to create income stability in retirement, it’s critical to reassess your retirement goals and income needs when faced with a pension buyout. If you are not 100% funded for your retirement, you are losing a measure of financial security, not getting an additional couple bucks of extra fun money today. I’ve seen people who are not prepared for retirement take lump sum pension buyouts and use the funds to build a pool in their backyard, which is a poor financial decision.
The good news is the buyout options can be used to replace some of that lost financial security. Which buyout option is best for you depends on your tolerance for risk and your level of discipline.
Assessing Buyout Options
Let’s say we have a married 41-year-old investor who is facing a pension buyout. He is given three options:
- Receive a fixed $150 per month from now until you die.
- Receive a fixed $1,080 per month from age 65 until both you and your spouse have passed.
- Take a $40,000 lump sum payment today.
The best way to assess the value of each option is to take the net present value of each option, accounting for inflation and investment returns. The risk tolerance of the investor will make a big difference in which option will make the most sense.
Let’s assume our investor is relatively conservative and expects both him and his spouse to die when he is age 95. If he received the lump sum, he might put it in cash, money market funds, certificates of deposit, bonds, or some combination of the prior. Assuming a 3% inflation rate and average returns on investments of 4%, here is the net present value of each option:
- The $150 per month is worth $41,116.
- The $1,080 per month is worth $91,812.
- The $40,000 lump sum is worth $40,000.
In this case, that investor would be much better off with option 2 from a pure financial perspective. If the investor had a higher tolerance for risk, the net present value of the pension cash flows would drastically change. Let’s say this investor has a growth objective and would invest in a portfolio with about 80% in stocks and 20% in fixed income. If we expect this investor to receive average investment returns of 8% and keep all other assumptions the same, this is how the numbers change:
- The $150 per month is worth $23,912.
- The $1,080 per month is worth $25,326.
- The $40,000 lump sum is worth $40,000.
The lump sum option is the clear winner in this case. By the time the investor reaches the age of 65, he would have $258,150 to spend in retirement. However, consciously choosing to invest does require discipline.
If you feel like you have a high tolerance for risk but may not follow through on investing the funds once they come over, either enlist a professional to support you with investing or consider one of the income options. You should also be moving from a pension payout into another retirement account to avoid taxes and penalties in the year of the buyout. If you may be inclined to cash out, I would once again advise considering an income option to force discipline.
Additional Considerations
Some factors that were not considered in the prior examples for ease of calculation. Future income taxation is nearly impossible to predict but varying taxation could slightly alter the calculations. Additionally, mortality at age 95 was assumed. According to the Social Security Administration’s mortality tables, an average 41-year-old is only expected to live an additional 40.15 years to die at 81 years old. Going off average mortality rates would make each of the income options less attractive and the lump sum option more attractive.
Conclusion
When faced with a pension buyout offer, it’s essential to carefully assess your options to ensure long-term financial stability. Each buyout option—whether it’s a lump sum or a lifetime income—comes with its own set of risks and benefits. By evaluating the net present value of each option and considering your risk tolerance, investment discipline, and retirement goals, you can make an informed decision that aligns with your financial needs. Additionally, consulting with a financial professional can provide valuable insights and help you navigate the complexities of your pension buyout, ensuring that you make the best choice for your future.
This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-7197192.1 (10/24)(exp. 10/28)