You’re about to retire on a $3,000 monthly pension. Your employer wants to know if you’d rather take only $2,500 but have the checks continue as long as either you or your spouse is alive. Or maybe you’d like to trade it all in for a tempting lump sum of $470,000.
What’s the best deal?
That’s a tricky question, and you can bet that your employer will offer no useful advice on the matter. We have answers here: a calculatorand, just as important, a list of things to contemplate before making a choice. To use the calculator, open the file in Google Sheets, then make a copy. You can update the inputs on your copy.
The calculator has built into it the interest and mortality rates that drive the value of an annuity. The answers that it spits out may be bit of a surprise. For one thing, if a lump sum is offered (as it is for roughly half of pensions), it is more likely than not a rotten deal. Also: The different monthly payout options are supposed to be equivalent in economic value, but often they are miles apart.
Whatever you do, take your time. “This is a huge decision you’re making,” advises Ari Jacobs, a senior partner at Aon Hewitt, which helps employers design pensions. “This may be the most valuable or second most valuable asset you own.”
The traditional monthly pensions at stake here are becoming less common, especially outside government employment, but they are by no means extinct. There are 40 million accounts either accruing benefits or else frozen but vested. Standing behind these promises is a $2.8 trillion asset pile, not including assets of government funds.
Be careful with those lump sums. Employers have both the means and the motive to short-change you.
Plans are not required to have a lump-sum option at all. If they do have the option, so says a federal law, the sum offered must be fair. But in calculating what’s fair, employers are permitted to use corporate bond interest rates instead of risk-free Treasury rates, and they can use old mortality tables that understate life expectancies. Both of these tricks reduce the present value of an annuity.
There’s another subtlety, which could work for you or against. In its zeal for political correctness, the federal governmenthas set up a unisex mortality table. But women outlive men, so the official table is slanted against them. That is, the lump sums offered to them are especially unfair.
I estimate that you’d be offered $470,000 for a $3,000 monthly pension that is about to start at age 65. (I can only estimate because plans vary in how quickly they adopt interest rate updates.) If you are a 65-year-old nonsmoking female, the pension is worth more like $626,000.
Mid-career workers whose plans get terminated or who leave a job often get buy-out offers. The offers are dreadful. Reason: years of discounting at high rates. I estimate that a 45-year-old male who has accrued a $2,000 monthly benefit to start at age 65 would be offered $102,000 to forfeit his pension. Its value is more like $196,000.
What’s the motive for playing tricks on loyal employees? The employer is hoping to get long-term liabilities off its books as cheaply as possible. It can count on the fact that a lot of people will grab the lump sums either because they need the money right away or because they don’t realize how valuable annuities are in a world of low interest rates and nonagenarians.
Perhaps a third ofpensioners (and a much larger fraction of younger people whohave stopped accruing benefits) takelump sums when they are offered. I speculate that at least half of those opting for immediate cashare failing the marshmallow test.
Yes, some people should take the lump. Take itif you’re single and in poor health. Takeit if you’re 35 and getting bought out of a pension that’s going to be worth, assuming you don’t lose track of it between now and 2046, only $300 a month. In either of these cases, direct the money, without touching it, into an IRA.
But if you are healthy and 45 or older, you probably should elect the monthly paychecks, even if it means waiting 20 years for them. Don’t rely on your instincts to tell you what the income stream is worth. Bruce Schobel, a consulting actuary in Sunrise, Fla., is sometimes brought into a divorce case to evaluate a traditional pension benefit. “You end up with a value on the same order of magnitude as a house,” he says. “People are often very surprised by this.”
Once you are settled on taking the annuity, you will at some point have, if you are married, a further choice about what kind of survivorship benefit to get. (For some choices, your spouse has to co-sign.) This is where the calculations get complicated. In this situation you have to contemplate not just your own health but that of four other people, if we may call a corporation a person.
First comes your spouse. If that person is a healthy, younger female (no matter what your gender is), there is a high likelihood that you should choose the payout that has the lowest amount now but gives her 100% of that amount when you’re gone.
Next, the plan. Are its assets enough, or almost enough, to cover liabilities? If you didn’t just get a disclosure statement in the mail, retrieve one from your benefits department. A high funding ratio makes your income stream safe. That means future payments should be discounted using interest rates not far above the rates on Treasury securities. Discount rates matter, because they change the relative values of different payout options.
Then, the employer. It can’t walk away from its pension promises without going through a bankruptcy (meaning, probably,a liquidation, not a General Motors-style reorganization). What’s the likelihood of that? If you’re working for Procter & Gamble, low. If you’re working for a necktie manufacturer, it’s something to think about. Again: Higher risk = higher discount rate.
Finally, there’s the Pension Benefit Guaranty Corp., a federal agency that backstops pensions up to a certain amount. Just how much depends on things like your age and the survivorship percentage, but you’re probably good for the first $4,000 a month.
PBGC has a sickly balance sheet. When it runs out of dough, the U.S. Treasury might come to the rescue. But might not.
If you’ve got a $3,000 pension, a lot has to go wrong for you to lose it. Your pension fund has to go bust and your employer has to go bust and PBGC has to go bust and Republicans have to control Congress. That’s why your discount rates should probably be keyed to the Treasury yield curve.
Yikes! All these numbers! But my calculator does the work for you. You type in ages and genders and the monthly payouts for you and your survivor. (If you're single, you have to put in a dummy spouse, age 84, to get the thing to work.) You can leave the mortality adjustments where they are—when you open the Excel file, they are set at a number suitable for a nonsmoker in average health—or fiddle with them. Make your adjustment more pessimistic if you’re a smoker or more optimistic if your parents lived to 95.
A single Treasury rate (available at Yahoo Finance) is all you need for the discounting formula. Raise it a notch if you have good reason to be worried about checks bouncing.
Don’t sweat the adjustment factors. It would take a big swing to change your conclusion about whether the lump sum is a good idea or, if you’re not taking a lump sum, about which annuity choice has the highest value. The values will vary because in creating the options your plan probably uses goofy assumptions (like a 6% discount rate or a unisex death table).
Try the calculatorby plugging numbers into the spreadsheet. And then, if you are still tempted to take a lump sum and invest it, ponder three cautions raised by Chris Blunt, who is president of the investments group at New York Life Insurance. He’s prejudiced in favor of annuities—he sells them—but his points are compelling.
Investment genius. So, you’re as good as Warren Buffett now. What about when you’re 85?
Longevity insurance. Annuities deliver this by taking money from people who die young and handing it to people who live long. If you take the lump sum you lose the insurance.
Security. There’s a risk, particularly as you get older, that con artists will spirit away your investment account. They can’t do as much damage to a monthly check.
