Should you accept a pension buyout?

(MoneyWatch) Should you accept a lump sum cash-out of your pension from a former employer? A number of readers have received such an offer and have asked me whether this is a good idea. If you have a sizable pension, this is one of the most important financial decisions you'll make, so it pays to carefully consider the pros and cons.

One of our readers sent me his cash-out election kit to analyze (To protect his privacy, I'll call him "Jim" and refer to his former employer as XYZ Company.) Let's take a detailed look at Jim's offer. If you have a similar pension buyout offer, our considerations and conclusions for Jim will likely also apply to you.

Most Americans don't have sufficient financial resources for a traditional retirement of "not working" starting in their mid-60s. As a result, they'll need to squeeze the most reliable lifetime retirement income from their existing resources. So let's take a look at Jim's cash-out pension offer to see how he can maximize his retirement income.

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Jim is 51 years old and is married to Jo, who's 49. Jim worked for many years at XYZ Company, but he's since terminated his employment with XYZ and now works for another company; in pension lingo, Jim is a "vested termination." Most buyout offers made today are for former employees with a vested pension benefit who haven't yet started their retirement income. These buyouts typically aren't offered to retirees who've already started their pension, although Ford and GM made headlines earlier this year by offering buyouts to current retirees.

XYZ Company gave Jim a choice of one of the following options:

If Jim elects the monthly pension, then he can also elect a joint-and-survivor annuity that would continue monthly income to his wife Jo after Jim passes away.

Because Jim is currently working, it makes no sense to start his pension immediately, so we'll dismiss that option from the get-go.

So here's the real question: If Jim takes the lump sum, can he generate a lifetime monthly income at age 65 that's bigger than $1,870 per month? As it turns out, after working through the numbers, I determined that it will be hard for Jim to do this. I estimated Jim's retirement income if he had elected the lump sum cash-out and used three different options to generate retirement income:

The graph below compares the estimated retirement income under these three options to the retirement income he'll get if he simply waits and takes the monthly retirement income from the XYZ Company Pension Plan.

The graph shows that it would be very unlikely for Jim to be able to generate a monthly income from his lump-sum payment that's greater than simply taking the monthly retirement income from the XYZ Pension Plan.

Why does the XYZ Pension Plan generate more income than the three options? The answer depends on the specific option.

The first two options involve buying an annuity from a commercial insurance company. The IRS allows employer-sponsored pension plans to use actuarial assumptions for determining lump sum cash-outs that are more favorable than the assumptions that insurance companies use to price their annuities. In addition, insurance companies need to build in margins for profit and administrative expenses, while employers operate their pension plans on a nonprofit basis.

With the third option -- systematic withdrawals -- the so-called "safe" withdrawal rate is purposely set conservatively so the retirement savings can withstand "worst-case" scenarios (for example, the retiree living well beyond average life expectancies or experiencing poor investment returns).

Stay tuned for my next post on this topic, which explains my calculations in more detail. A third post will discuss considerations other than the amount of retirement income, and answers some questions that individuals commonly ask about these buyout offers.

[JP3613]

Good article. Many Americans don't know that if they elect monthly payments they can later convert the future pension payments into a lump sum commonly referred to as Pension Funding. Contact the pension funding group for more information. www.pensionfundinggroup.com

[JP3613]

Good article. Many Americans don't know that if they elect monthly payments they can later convert the future pension payments into a lump sum commonly referred to as Pension Funding. Contact the pension funding group for more information. www.pensionfundinggroup.com

[JP3613]

Good article. Many Americans don't know that if they elect monthly payments they can later convert the future pension payments into a lump sum commonly referred to as Pension Funding. Contact the pension funding group for more information. www.pensionfundinggroup.com

[ChuckYanikoski]

I am not totally unbiased on this issue, but if it were me (or someone else I cared about) I would advised them to take the Lump Sum, invest it conservatively for a few years, and then, assuming that interest rates return to something resembling normal, look into buying some kind of fixed annuity at that point. My bet would be that the outcome would be a much better benefit than the DB amounts currently being offered.

[stevevernon]

Hi readers - stay tuned for my posts on Friday and Monday that dig deeper into the issues and answer your questions about bankruptcies, mergers and selloffs. Best regards, Steve

[chesterariley]

Careful. Not all defined benefit plans preserve value if you defer your pension start date and die. In fact, some plans only provide a death benefit -- and a decreased one at that -- only if you have been married at time of your death for at least a year.

[hypnotoad72]

Take the money. With the bankruptcies and selloffs due to mergers and other breakdowns in society*, is the money better with you or better for the CEO as they protect themselves at everyone else's expense (again)?


* if you think putting money into a venue that people also say "don't put to invest what you cannot afford to lose", especially if money is being forced out of your account...

[wangfoy]

I just took the buyout as a lump sum and this was exactly why. Proportionately speaking, my numbers were similar to those in this article and while I probably would have eecked (sp?) out a little more staying with the pension, my former employer is not doing well and is regulated by bureaucracies on two continents and so with my life expectancy of 40+ years, that's a lot of time for someone else to squander my money. For me, a bird in hand is worth 2 (or 10 for that matter) in the bush.

[rvchamb]

is there any scenario where this individua would take the pension now and invest the receipts and then have the benefit of this smaller annuity at retirement plus the reinvested lump sum to additionaly draw off if needed.. ?

[pgb]

Thanks for showing us how to work through this decision. But you didn't mention one factor that I wonder about: what's the risk that XYZ company will be unable to fulfill its pension obligations and that Jim will be left with nothing when he retires? Are the pension obligations of private companies as unsustainable as those of governments?

[1notrub11]

A very valid question and one I considered as well. I would think it would depend on the company. Nevertheless, if said company had to declare bankruptcy, I am not sure what their obligation would be, assuming they restructured. It may not be as solid as one might expect.