Kudos to the American Academy of Actuaries (AAA) for releasing a new Issue Brief encouraging public pension plan administrators to provide eligible plan members with certain reference amounts when offering lump-sum “buy-outs” in exchange for some or all of their pension benefits The Issue Brief concludes, “members may find the following reference amounts particularly helpful:
- An estimate of the cost to replace any benefits otherwise payable in the private
market; and - The approximate annual investment return on the buyout amount required to replace
the forgone benefits, assuming an average life expectancy.”
In addition, AAA also encourages disclosure of the assumptions used to develop the buy-out offer (and also presumably disclosure of the assumptions used to develop the above reference amounts.)
The AAA Issue Brief includes example calculations for different types of members. The first example involves a 62-year-old member (sex not provided) who appears to be eligible for an immediate retirement benefit of $2,500 per month payable for life with 2% per annum annual increases. The annuity cost estimate included in the example appears to us to be somewhat high (even for a female) given current annuity purchase rates available from Immediateannuities.com, but that doesn’t affect the points we are trying to make in this post.
We have written frequently regarding the financial advisability of electing lump sums vs. lifetime benefits, including our posts of:
While the primary focus of these posts was lump sums offered by private pension plans subject to Section 417 (e) of the Internal Revenue Code (which provides more protection to plan members than in the public sector), the comparison concepts are similar. In each of these posts, we encouraged eligible plan participants to obtain annuity quotes and to input the two alternative choices in our spreadsheets to see the potential impact on their actuarial balance sheet and Funded Status.
The AAA’s two reference measures are based on life expectancy (50% probability of survival), while the default assumptions in our Actuarial Financial Planner spreadsheet are based on the 25% probability of survival from the Actuarial Lifetime Illustrator for non-smokers in excellent health, which produces a lifetime planning periods that are typically 5-6 years longer than life expectancy. As discussed in our post of September 14, 2021, we believe that you should plan on living longer than your life expectancy, and therefore, if your spending liabilities are calculated based on the assumption of living longer than your “expected” lifetime, your lifetime income assets should be calculated on the same consistent basis.
The AAA actually agrees with this more conservative planning principle. In its Actuarial Lifetime Illustrator FAQs it says,
“If you plan for living only as long as your life expectancy, you may outlive your financial resources because there is a significant chance that you will live longer than that.”
Using the default assumptions 1 for the AFP and the data from the AAA’s first example, we calculate the present values of the example benefits for a male and a female using the AFP as follows:
Sex | Annual Benefit | Deferral Period | Payment Period (LPP) | Annual Increase rate | Interest Discount | Present Value |
Male | $30,000 | 0 yrs. | 31 yrs. | 2% | 5% | $622,510 |
Female | $30,000 | 0 yrs. | 33 yrs. | 2% | 5% | $646,589 |
By comparison, if we had assumed 50% probability of survival for non-smokers with excellent health from the Actuaries Longevity Illustrator, we would have developed the following present values:
Sex | Annual Benefit | Deferral Period | Payment Period | Annual Increase Rate | Interest Discount | Present Value |
Male | $30,000 | 0 yrs. | 26 yrs. | 2% | 5% | $555,835 |
Female | $30,000 | 0 yrs. | 28 yrs. | 2% | 5% | $583,670 |
1 Note that the AFP assumes beginning of year payments for income and expense streams. Also note that LPPs from the current version of the AFP are 1 year higher for males and females than the current version of the ALI.
The key takeaway from these charts is that if your personal financial plan in retirement involves living 5 or 6 years longer than you expect, the value of lifetime income sources increases significantly relative to your spending liabilities, and this fact should not be ignored when making planning decisions.
Another reason we recommend using the AFP to facilitate these types of decisions is because it compares the present value of household non-risky investments with the present value of household essential expenses, consistent with Liability Driven Investing (LDI) theory. Pension benefits are generally considered to be relatively less risky than most other types of investments, and are therefore ideal for funding essential expenses. This concept is not totally dissimilar from the AAAs suggestion that investment returns on the lump sum to make the member whole be disclosed, as higher implied returns will indicate more risk associated with the lump sum option.
From both these perspectives, then, it would appear to be pretty clear that unless the member has reason to believe that his or her LPP is significantly shorter than the default assumptions in the AFP and/ or she has already sufficiently funded her essential expenses, the example member should not elect to receive a lump sum of $293,000 in lieu of her pension benefits under the plan. Doing so would have a significantly negative impact on her household balance sheet and Funded Status.
Conclusion
Choosing between receiving a lump sum and a life annuity is a decision that requires some amount of number crunching to get it right. In addition to the two items suggested by the AAA, we recommend that members (and/or their financial advisors) input the alternatives in our Actuarial Financial Planner to see the potential effect on their balance sheet and Funded Status.
