In light of ever-increasing flat dollar premiums charged by the Pension Benefit Guaranty Corporation, changes in the IRS mortality tables used to determine minimum lump sum values scheduled for 2016 and other reasons, more defined benefit plan sponsors are likely to settle some or all of their pension plan liabilities in 2015. Settlement of pension liabilities generally involves transfer of the liability to an insurance company (through annuity purchase), lump sum window offers to participants or a combination of the two approaches. This post will provide a process that retirees can use to evaluate some of the financial implications associated with a lump sum buyout option and will illustrate the process with an example. Note that the recommended “number crunching” that follows applies equally to a pension plan participant who is retiring (or near retirement) and is being given an option to take a lump sum in lieu of a lifetime income form of payment.
Many articles have been written about the pros and cons of taking lumps sums in lieu of promised pension annuity payments. Even though pension plan participants have been choosing between lifetime income and lump sums for years, this issue gathered significant media attention several years ago when both GM and Ford opened lump sum buyout windows to some of their plan participants who had already retired. The Pension Rights Center has a web page with several articles generally encouraging retirees to reject the lump sum option.
In general, I agree with the experts who encourage retirees to stay with the annuity (payable either from an insurance company or from the plan) rather than take the lump sum. The advantages of doing so are clearly set forth in the Pension Rights Center material (and elsewhere). But, interest rates to determine lump sums are currently very low, and retirees may be legitimately tempted by the amount of the lump sum offer they may be eligible to receive and roll over to an IRA. As a retired actuary, I am always interested in crunching numbers before I make important decisions. If you receive a lump sum buyout offer, I encourage you to get some annuity quotes and use the Excluding Social Security spreadsheet on this website to give yourself some additional financial “data points” so that you can properly make your decision.
To illustrate the approach I would use, let’s assume we have a single male 65 year old retiree named Rick with accumulated savings of $500,000, a $24,000 annual pension and an annual Social Security benefit of $20,000. Rick used the spreadsheet on this website and the newly revised assumptions to develop a spending budget for 2015 (assuming zero bequest motive) of $59,523 ($15,523 from savings, $24,000 from pension and $20,000 from Social Security). Shortly thereafter, Rick receives a lump sum buyout offer of $327,200 in lieu of his life annuity payment of $24,000 per year. What should he do?
Recalculate Spending Budget
The first thing Rick does is go back to the spreadsheet to see what the impact would be on his 2015 spending budget if he had an additional $327,200 in accumulated savings (by taking the lump sum and rolling it over to his IRA) but no pension income. Under the recommended assumptions, these changes would produce a $55,985 spending budget ($35,985 from accumulated savings plus $20,000 from Social Security). Rick then plays around with the spreadsheet to determine what additional investment return he would have to earn on the lump sum amount or decreased payment period would make up for the $3,538 decrease in his spending budget. He determines that he would have to earn an additional 2% real rate of return (or approximately a 4% real annual rate of return) on the lump sum or reduce his expected payout period with respect to the lump sum by about 8 years.
Determine Cost of Immediate Annuity
The next thing Rick does is see how this lump sum offer compares with approximately how much it would cost to purchase an annuity that provides the same level of benefit as his pension. He goes to Immediateannuities.com and (as of February 18, 2015) determines that the approximate purchase price of an annuity providing $2,000 per month for him commencing next month is about $363,600 (he lives in California), or about 11% higher than the lump sum offer. If he were serious about buying an annuity with the lump sum (or if his pension annuity were not a single life annuity), he would need to obtain an actual quote. However, the information from this website is reasonably sufficient to tell Rick that the lump sum offer is probably less than the market value (or purchase price) of his pension annuity. Note that if Rick were a female, the immediateannuities.com quote is currently about 20% higher than the $327,200 lump sum offer. Since pension plan lump sum offers are based on unisex mortality assumptions (and will therefore be equal in amount for males and females of the same age with the same benefits) and annuity rates from insurance companies are higher for females than males, a pension lump sum offer will almost always be more favorable for males than females when measured as a percentage of the market value of the annuity.
Determine Cost of Deferred Annuity and Consider Partial Annuity/Partial Self Investment Approach
By looking at approximate immediate annuity costs, Rick has determined that he probably cannot take the lump sum, roll it over to an IRA and buy an immediate annuity that replaces the benefit provided by his pension. This is not terribly surprising since if an immediate annuity could be purchased for less than the lump sum cost, the plan sponsor could simply settle Rick’s pension liability at less expense by purchasing the annuity itself. Rick wonders, however, if he can elect the lump sum, roll it over to an IRA, buy a deferred annuity (also referred to as a longevity annuity or QLAC), with a portion of the lump sum and invest the remainder of the lump sum and come out ahead. He goes back to the immediateannuity website and enters “20” years for commencement of the $2,000 per month annuity. As of February 18, the amount shown to purchase this deferred annuity is $63,776. So he can spend $63,776 to replace the pension annuity payments he would have received from his pension starting at age 85 and invest the remaining $263,424 ($327,200 minus $63,776). He goes back to the “Excluding Social Security” spreadsheet and enters $763,424 in accumulated savings, $0 immediate annuity, $24,000 deferred annuity and a 20 year deferral period. Under this scenario (and recommended assumptions), his 2015 spending budget would be $57,243 ($37,243 from accumulated savings plus $20,000 from Social Security). This budget amount is more than the budget determined above with no annuity income, but less than the original 2015 budget with his pension. Rick can play around with the assumptions in the spreadsheet to see what real interest rate or expected payout period would close the gap. Again, if Rick were serious about pursuing this route, he would probably get an actual annuity quote.
Based on his thorough analysis which included the calculations above, Rick decided to keep his pension annuity. Your decision may be different based on your analysis and the amount of the lump sum you are offered. But, as always, if you are doing this analysis on your own, I encourage you to crunch your numbers and think about the three major assumptions (investment return, inflation and longevity) used in the calculations. A decision with respect to a lump sum offer could be one of the most important financial decisions you make in retirement.