Should you accept a pension buyout? A closer look

(MoneyWatch) My last post analyzed a reader's pension buyout offer, and showed that "Jim" would most likely receive a higher retirement income by simply staying in the plan until retirement and receiving the monthly income under the plan. Jim, currently age 51, is entitled to receive a monthly retirement income of $1,870 beginning at age 65. His company has offered Jim $126,000 payable immediately to forgo the monthly income at age 65.

I estimated the amount of retirement income Jim could generate from the $126,000 payment under three different methods of generating retirement income. This post provides details on the calculations; you'll want to read my last post for more background on Jim's circumstances.

Option 1: Invest his lump sum now, and buy an immediate annuity at age 65.

Jim could invest his lump sum until age 65 and, at that time, buy an immediate annuity from an insurance company that pays a retirement income for the rest of his life. Let's suppose Jim invests in a portfolio balanced between stocks and bonds and earns 6 percent per year from age 51 to age 65; in this case, his $126,000 lump sum payment would grow to almost $285,000. This amount would buy a monthly income of about $1,540, using current annuity purchase rates for a 65 year-old man from Hueler's Income Solutions annuity bidding platform.

For Jim to invest his money for 14 years and then buy a monthly annuity of $1,870 -- the amount he's guaranteed from the XYZ Company Pension Plan -- he'd need to earn about 7.5 percent per year for 14 years. While that's possible, he would need to take substantial risk in the stock market to earn 7.5 percent per year -- or even 6 percent per year. And he could earn a lot less, or even lose money in the stock market. So this doesn't seem like a reasonable way to generate a reliable retirement income that's higher than $1,870 per month.

Option 2: Buy a deferred lifetime annuity.

Jim could take his lump sum and buy a deferred lifetime annuity from an insurance company that starts at age 65. New York Life is one of the largest providers of deferred fixed annuities, and I used their annuity rates to estimate that Jim could buy a monthly annuity of between $1,250 to $1,450 with a current investment of $126,000. I had to estimate the annuity because their rate sheet doesn't have annuities that are deferred 14 years from age 51 to age 65. So this route would definitely not generate a higher monthly income.

Option 3: Invest his lump sum, and use systematic withdrawals at age 65.

Jim could invest the $126,000 in a portfolio balanced between stocks and bonds and, when he retires at age 65, start withdrawing from his portfolio cautiously to avoid running out of money before he dies. Many financial planners advocate using the "four percent rule" that generates an initial annual retirement income of four percent of the account balance. Although some analysts have currently been questioning whether a four percent rule is safe considering the current low level of interest rates and the potential for high fees for investment management and/or financial advisors, for the sake of argument, let's still use a four percent withdrawal rule.

Suppose again that Jim earns 6 percent per year from age 51 to age 65, and that his lump sum payment grows to about $285,000 by age 65. Four percent of this amount would generate an annual retirement income of $11,400, or a monthly income of $950.

Let's now suppose that Jim earns 10 percent per year from age 51 to age 65 -- quite a stretch and something that would require Jim to take a lot of risk in the stock market. Then his $126,000 lump sum payment would grow to almost $480,000; four percent of this amount generates an annual retirement income of $19,200, or $1,600 per month.

So it looks like investing his lump sum payment and using systematic withdrawals to generate retirement income also won't beat taking $1,870 per month from XYZ's pension plan.

By the way, the results of the analyses for the first two options aren't knocks on Hueler's Income Solutions or New York Life; both of these institutions deliver competitively priced annuity products. As noted in my prior post, the IRS allows pension plans to use actuarial assumptions to calculate pension cashouts that are more favorable than realistic assumptions used by commercial insurance companies.

These analyses show 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. Stay tuned for my third and final post on this topic, which looks at considerations other than the amount of retirement income, and answers some questions that individuals commonly ask about these buyout offers.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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