Many employers are offering workers with traditional defined benefit pension plans a chance to exchange their guaranteed lifetime income at retirement for an immediate lump sum payment. Typically, these offers are made to employees who've ended their employment but haven't yet started receiving retirement income.
Two major reasons explain why companies are making these offers:
- Employers want to reduce the risk and uncertainty that comes with offering a monthly income that lasts the rest of your life, no matter how long you live. They'd rather trade a known amount today -- a single payment -- for an unknown liability that will stretch many years into the future. In pension jargon, this process is known as "de-risking."
- Pension laws and regulations allow defined benefit plan sponsors to offer lump sum payments that usually amount to less than the market value of the monthly income. The laws and regulations allow the plan sponsor to make assumptions about how long you'll live and the interest rates on invested assets that are more favorable (from the plan sponsor's perspective) than the assumptions that insurance companies use to price annuities.
Recently, a few readers sent me the details about their offers. So far, each offer involved a lump sum payment that was less than the purchase price for an equivalent annuity. In these cases, then, if you took the lump sum, you'd need to take substantial stock market risk to invest your money and use systematic withdrawals to generate a higher amount of retirement income.
What does this mean if you've received such an offer? Most people should turn down the lump sum offer and stick with the guaranteed lifetime payout. If you have any doubt about what to do, stick with the lifetime retirement income. The uncertainty over how long you might live is a significant retirement planning challenge. So when a credible entity (your employer) offers to pay you a retirement income for the rest of your life, that's usually a good deal.
When should you accept the lump sum? Here are some circumstances in which that is the better option:
- You (and your spouse or partner if applicable) are in poor health and don't expect to live very long.
- You have enough retirement savings so that you're financially secure without the pension (Bill Gates wouldn't sweat this decision, for instance.)
- You're certain that you can successfully invest and manage a lump sum to generate retirement income for the rest of your life -- no matter how long you live -- and that you can achieve favorable investment returns over your entire lifetime.
- You're worried about the financial security of your pension plan. This should only be a concern if all three of the following conditions are present: (1) Your monthly benefit is far higher than the amount guaranteed by the Pension Benefit Guaranty Corporation (PBGC); (2) you believe your company might go bankrupt in the future; and (3) your pension plan is or will be underfunded when your employer goes bankrupt.
In 2014, the PBGC guaranteed pension payouts of $4,943 per month for a 65-year-old retiree with a single life annuity payment or $4,449 for a 50 percent joint and survivor annuity. If you start your pension earlier than age 65, lower limits apply.
On the other hand, you should consider taking the guaranteed monthly income if any of the following conditions apply:
- You or your spouse are in average health or better.
- You like the guarantee of a monthly lifetime income that's very user friendly (the money is automatically deposited in your account each month).
- You're concerned about your ability to successfully invest and manage the lump sum amount over your lifetime, a period that could last 20 years or more.
- You're concerned about your interest or ability to manage your money in your 80s and beyond.
- Your monthly benefit from your plan is below PBGC guarantees.
Let me be clear: The sponsors of defined benefit plans aren't bad guys for offering lump sum cashouts. They're prudently managing their risks within the limits allowed by federal pension law. Traditional pension plans are a dying breed, and I applaud the employers that still offer these valuable plans.
It's also entirely understandable if you need professional help with this decision. If you ask a financial advisor to help you, however, be wary of people who have a financial stake in your decision (meaning they want to invest your pension payment for you). If you hire someone to help you, make sure they're trained in the complexities of generating retirement income, and make it clear you won't give them your money to invest.
If you're offered a lump sum cashout, chances are it's one of the most important decisions you'll make about your retirement security. Don't be influenced by the decisions of your work friends; chances are good they didn't give it much thought or that their circumstances could be different from yours. Give this issue a lot of thought before making your decision.