By Michael Lynch, CFP
The traditional defined benefit pension may be on its way to extinction. But according to the Congressional Research Service, 24% of civilian workers still have one, including one-in-seven private sector employees. Given that more than 153 million Americans suit up for work each week, tens of millions can look forward to some sort of pension at some point. If you’re one of these lucky people--and you plan to retire soon--tens of thousands of dollars may hinge on your nailing down your plan’s particulars.
Get the Skinny on the Formula
First, call your employer’s human resource department, go online, and do whatever it takes to determine the parameters of your future payday. Will you be forced to take a monthly annuity, an income for life? Or will you also have the option to elect a lump sum as a full or partial exchange of the annuity?
I’m shocked at how few people I encounter understand even the basic features of the pensions they are promised. This is all available in the Summary Plan Description (SPD). Your friendly human resource professionals will happily send it to you or tell you how to access it. The plan will be long, but it’s written so simply that even I, someone blessed with an off-and-on public education, can understand it. And it comes with a table of contents so you can skip the really boring stuff.
If the plan offers only a monthly benefit, you should figure out the formula and apply it to yourself. As I detailed here, inflation is the enemy of annuity pensions. If the formula is based on the highest five years, and you have some big salary raises on the way, it may pay for you to sit tight a few extra years. Or it may be that the formula increases your benefit substantially once you meet certain milestones. The Rule of 85 is a common one, which means once your age and years of service reach 85, your benefit gets very large. (For example, a person aged 55 with 30 years of service could retire on full pension.) It’s best to get mentally prepared now for the time you’ll serve.
This is the path Rick is plodding down. At age 55, he’s set financially. A lifetime of diligent savings, smart investing, and an early stint counting beans for a state government means he can quit his current job today. This job is stressful, he’d love to leave – except it’s not a smart move.
Rick is currently vested in a private-sector pension at his current job. At age 56, it would pay $3,000 a month for the rest of his life. Not too shabby. His financial plan shows he could shove off and be done with the 9 to 5. Yet because of a formula in his pension, he’ll pocket $5,800 a month if he remains employed and a little stressed to age 59. Three years puts $2,800 a month more in his pocket for as long as he remains on the right side of the grass. It takes him only a little over three years to make up all the money he gave up by not leaving at 56. That’s his “what if I die?” breakeven. If he lives 26 years to age 85, the three years of extra toil will produce $765,600 in nominal money. That’s $255,000 for every extra year of work.
Is this worth it? I suspect most people would answer yes. That’s Rick’s position. I remind him of the lifetime value every time we speak.
Take the Money and Run
Pre-retirees who have a lump sum option may want to follow the opposite strategy: take the money and run before the formula changes. Some hitters should bunt. Others are wise to swing for the fence.
Pension math, like anything that derives from the intersection of government and large corporations, can be a bit baffling. But the core concept is that the lower the interest rates, the larger the lump sum a company must provide to buy you out of taking a stream of monthly payments.
Upon reflection this makes sense. A pension, as I detail in my most recent book, It’s All About the Income (Lioncrest 2022), is essentially liquidating a sum of money, together with the interest it earns on the declining balance, over a person’s life expectancy. The lower the interest rate, the more money is needed to generate the level of income. Higher rates, less initial money. The lump sum is the initial money.
No More Dynamite!
The table below illustrates this well. This is not a real-life example of a pension. Actuaries would not make the big bucks if it were this simple. But it does illustrate the mechanics.
In this case, the fabled ACME Corporation is on the hook to pay Wile E. Coyote, after years of doing his best to destroy Roadrunner, a monthly retirement income benefit of $5,000. The corporation, which (as one episode indicates) is owned by Roadrunner, has promised to finance a fixed portion of Wile E.’s monthly income needs.
Wile E. has a statistical life expectancy of 15 years. He’s 60 now and coyotes, on average, make it only to 75. If ACME assumes it earns 6% on the funds it is paying Wile E., it needs just under $600,000 when he commences his retirement. If interest rates are in the tank and it can safely earn only 4 percent, the initial lump sum increases by 15% to roughly $675,000.
Less Is More and More Is Less
It may be counterintuitive, but low rates are your friend if you have a lump sum pension option. High rates are your enemy.
Why does this matter? You may have noticed that interest rates are spiking off historic lows, and this won’t be good for your lump sum. Each pension plan sets its rates at different times, but many do it once a year, late in the year. If this applies to your plan, the lump sum you’re quoted today is likely based on 2021 low-interest rates. Wait until 2022 and you may do a Wendy’s “Where’s the Beef?” when you confront the 2023 offer.
This shrinkage may also make the after-tax value of working an extra year or even a few extra months paltry if not negative. Consider Wile E., who was taking down a considerable $150,000 a year as he approached retirement, much of the comp in hazard pay. If he worked an extra six months, his entire pretax salary of $75,000 (half of $150,000) would have been consumed by his reduced pension.
One Day May Cost You $100,000!
I saw this back in the late 2000s when a company at which I taught financial planning classes allowed employees to model the pensions based on current and future-year projections. Although the monthly benefit stayed the same, the lump-sum offer of one soon-to-be retired was reduced by six figures—more than he’d earn if he’d worked the entire year—if he left in January as opposed to December. If he worked one month, he would lose more than a year’s salary in a reduced lump sum payout.
Thanks to good planning, that man left with a smile and a seven-figure check. He got a free year of life.
Not a bad payday for spending a little time analyzing.
It May Matter even if You Plan to Take the Monthly Check
You might be tempted to relax and write off the above as hysterics of an overanalytical financial planning dork. After all, you plan to take the monthly benefit. That’s not changing and, unlike the highly stressed Rick, you’re not working a few years more to boost your payout. You’re leaving soon and your monthly mailbox money will not be affected by any of these analytics.
In the past, I’d have agreed with this logic. A recent planning case, however, rocked my world. I saw something I’d never seen before. I’ll get to that in a minute. First, the background.
My engagement centered on straight fee-only retirement planning for Roy, a 58-year-old man who, like Rick, was sick of his job. Examine the facts, model the options, and advise on the best course of action. Roy had a complex pension. It offered a straight life annuity (SLA), lump sum, partial lump sum, and even an inflation-adjusted option. This is just the sort of thing that prompts academics to quiver with delight.
Getting paid to dive into this is not a bad way to spend the day. It was just the sort of job that provided an excuse to break out the Excel spreadsheet.
I ran the lump sum versus the SLA as a liquidation percent. It came to 5.4%, as the table below illustrates. In other words, the pension offer was just over $2,060 a month for the rest of his life. He could take this or $460,000. The liquidation percent was 5.37%. This too was not surprising, given the many pensions I’ve analyzed in recent years.
My Shock and Delight
As a general practice, we always check a lump sum and annuity option against what a lump sum could purchase in the private single premium immediate annuity (SPIA) market. For example, in this case, the lump sum offer is $460,000 and the monthly payment option is $2,060. This transparency makes it easy to verify the value of the deal.
We know the age, so we take the lump sum and see how much monthly income this will purchase from a highly rated insurance company. These private annuities pay commissions to agents, so it stands to reason that they pay less, per dollar of the lump sum, than the employer’s annuity offer.
The World’s Changed—At Least for Now
I was shocked when I checked and found that the lump sum would purchase $2,399 in monthly income from a highly rated insurer on the open market.
That’s right! If he took the lump sum and purchased a single premium immediate annuity (SPIA) from a highly rated insurance company instead of letting his former employer send him the funds, he stood to get $2,399 instead of $2,060 a month.
I could not believe it. I don’t recall ever witnessing a commission-loaded SPIA beating a group annuity by more than 15%! I double-checked with multiple carriers. The results were replicated across multiple companies. It’s true, at least for now.
Take the Income and Pocket the Change
This opened a world of favorable options for Roy and may do the same for you. Recall that he had the lump sum option or the annuity option. In this case, a private insurance company would match his pension option for only $395,000. That is, he could take the lump sum, transfer $395,000 of it to an insurance company in exchange for $2,060 for the rest of his life, and invest $65,000 in an IRA to use as he pleases.
Once he is in the world of lump sums, he can select his monthly income amount. No need to be tied to the company’s preset options. The takeaway is that he is getting a much better deal in the private market. As you can see from the table, the increased annuity income will pay out just over $100,000 more than the pension if Roy makes it to 85 and plenty more if he keeps on going. If he uses the lump sum to match the employer pension, it frees up $65,000 immediately.
Consider the Risks
Life is all about tradeoffs and we are rarely comparing apples to apples. Corporate pensions are governed by the Employee Retirement Income Security Act of 1974 or ERISA. This means that they are guaranteed by the federal government through the Pension Benefit Guaranty Corporation (PBGC) up to preset limits by age. The PBGC would fully guarantee my client Roy, at age 58, against default for a monthly pension of up to $3,537. This more than covered his amount.
Once he steps out of the ERISA-protected world, he loses this backing. In the private annuity space, the income is backed by the claims-paying ability of the carriers with some additional protection provided at the state level. That is why I compared only highly rated carriers. Is the PBGC protection worth a 15% reduction in income? $65,000 today? $109,000 by age 85? Some people may say yes, others no. There is no right or wrong answer here. It is important that you understand the tradeoffs and draw your own conclusion.
Limited Time Offer
This opportunity is not likely to stick around for long. I am no actuary, and I don’t work in any pension department or for any insurance company. That said, my hunch is that this money shot is the result of private insurers responding quickly to rising interest rates and corporations adjusting their assumed interest rates annually.
The purpose of this article is to ring the bell alerting you to the opportunity to potentially make some lemonade from the lemons this year’s financial markets have offered up. To paraphrase the counsel of the Zac Brown Band in its song “Let it Go,” when a pony comes a-walking by, you might want to put your rear end on it.
About the author: Michael Lynch, CFP®
Michael Lynch is a financial planner with the Barnum Financial Group in Shelton, CT, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020, and It’s All About the Income: A Simple System For a Big Retirement, May 2022. You can find more articles and videos at www.simpleandbig.com. He can be reached at firstname.lastname@example.org or 203-513-6032.
Securities, investment advisory services, and financial planning services are offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to be complete or to cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should confer with their qualified legal, tax, and accounting advisors as appropriate. CRN202507-2830038