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According to the 2016 Federal Reserve Survey of Consumer Finances, only 13% of non-union private sector workers are currently participating in a defined benefit (DB) pension plan. You remember those, right? You work at a company for decades, retire when you hit your 60’s, take your gold watch, and start collecting checks every month for the rest of your life.
But the percentage of private sector workers covered by pensions has dropped by half in just over the last decade or so. This has happened for a variety of reasons. For a while, companies that had overfunded plans were sought out in mergers so that the acquiring company could take out the excess. This was the premise for Gordon Gecko buying out Bluestar Airlines in the 1987 film, Wall Street.
More recently, many companies with underfunded plans have had to be bailed out by the Pension Benefit Guarantee Corporation (PBGC). In the 2008 recession, many real airlines did this to shed obligations. So many companies have done this, in fact, that the PBGC itself is now on shaky ground.
One of the results has been that the PBGC has had to raise their insurance premiums on existing plans. That, in turn, has made more companies consider terminating their pension plans due to the higher expenses and the liability reductions on their balance sheets.
If you are one of the few private sector employees left standing that still enjoys a DB plan, don't be surprised if your company offers you a buyout. I personally experienced this when my old employer terminated their plan during the financial crisis in 2008. Just in the last few months, I’ve helped clients from Accenture and Shell review similar offers, as well.
If you are unfortunate and your company hands your plan over to the PBGC, you won’t have many choices to make. They will continue your benefit, but almost certainly at a lower amount than was originally promised by the plan. However, if your company isn’t making changes under duress, you may be offered incentives to go away. The incentives I was offered, as well as those clients that I have recently analyzed, had certain similarities.
Here is a typical example. A 45-year-old female is offered three choices:
- An immediate monthly check of $420.
- A delayed monthly check beginning at age 69 of $1544.
- A lump sum payment today of $100,000.
For the purposes of today’s article, I will not include survivor options in the analysis, mainly because those decisions should be secondary to determining which of the three payout choices to take.
Immediate Monthly Check
Taking either of the monthly payment options provides the comfort of knowing that you can’t outlive the income. With the immediate option, you can start enjoying the money today, but that doesn’t mean there aren’t risks. Failure of the insurance company, inflation eating up the value of your check, or the inability to cash out early if you have an emergency are all potential downsides.
Also, it may be helpful to understand how a monthly payment for an annuity is calculated. The insurance company looks at the annuitant’s life expectancy (the period where 50% of a population are expected to survive) and interest rates (typically high-quality bonds) they can earn to calculate the amount they feel is reasonable to payout while remaining solvent.
Since we know that the immediate payment amount is $420 and that the lump sum amount is $100,000, we can calculate the return if the annuitant lives to certain ages.
Calculating the internal rate of return (IRR) for the annuitant dying at various ages results in the following:
75= 2.97% (Current 30 Yr US Treasury Bond @ 2.87%)
84= 3.96% (IRS Life expectancy for a 42-year-old)
When the annuitant dies, the checks stop. The longer you live, the higher your return.
Delayed Monthly Check
All the factors mentioned for the immediate check apply to the delayed option except, by waiting, you will get a bigger check. I have found that understanding how much it would cost to produce a similar income stream today can be helpful in determining if waiting makes sense. Since we don’t know what it will cost in 24 years to produce a lifetime monthly payment of $1544, we can use what it costs a 69-year-old today in order to get an estimate. (Understanding that interest rates and mortality tables may be different then.)
Using USAA’s Immediate Annuity Quote tool, I received a quote of $284,121 for our hypothetical 69-year-old female taking a monthly check of $1544 for life. Knowing this, we can do a similar analysis as we did with the immediate check.
87= 1.82% (IRS life expectancy for a 69-year-old)
With that estimate, we can also do some analysis on the third option, the lump sum.
Taking the lump sum and rolling it into an IRA or employer sponsored retirement plan maintains liquidity and maximum flexibility. Market risk is probably the most apparent downside to taking the lump sum today, as you would have to grow it so that it could produce income in the future. This is where the annuity quote comes in handy, as we can now simulate how likely it is that we can grow the $100,000 lump sum to the $284,121 estimate that will be needed to produce the income.
First, I calculated that a 4.44% compound annual return is needed to grow to our target amount over 24 years. Then, I looked at the likelihood of that happening. Using financial planning software from MoneyGuidePro®, I ran a Monte Carlo simulation of a 60% equity, 40% fixed income portfolio. Monte Carlo simulations model different outcomes based on varying sequences of expected returns. Think of it as having a deck of cards with each card representing a possible yearly return for a 60/40 portfolio. Deal the top 24 cards and then use those returns in that order to calculate how much money you have at the end. Shuffle the deck and deal 1000 more times, and you can get a pretty good idea of likely outcomes.
In this case the median outcome was $362,163, with the highest result being $921,735 and the lowest $133,461. With that information, you can make an informed decision about how much market risk the lump sum decision may involve.
In any event, there is no right or wrong answer. Some will be drawn to the comfort of a steady monthly check today or tomorrow, while others will prefer to shuffle the deck and deal. For all the choices, it comes down to a simple question.
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