What to Consider Before Taking a Lump Sum Buyout of Your Pension
In an effort to decrease pension obligations, many corporations have been offering current and former employees a lump sum to buyout their defined benefit pension plans. At first glance this may seem like a great opportunity and pension administrators say that 50% to 70% of those offered take the lump sum. Analyze this carefully; it’s an important and complex decision that is different for each individual situation.
Generally, the lump sum offer is based on an actuarial calculation indicating the present value of a pension’s income stream, based on your age and a reasonable rate of return. You can evaluate the relative value of the lump sum being offered by calculating the internal rate of return of the income stream or by running present value calculations using various rates of return and life expectancies. A fee-only financial planner or an accountant can help you with these calculations.
Life expectancy, which is readily available on the internet, is one of the biggest factors in determining the advisability of taking a lump sum. However, the typical life expectancy may not be applicable to you. Healthy individuals with a history of longevity in their family may live longer than the standard life expectancy. Alternatively, individuals with health issues or a family history with shorter life spans may anticipate a shorter life expectancy. Generally, monthly payments from a pension are better if you anticipate a longer life expectancy and a lump sum is better if you anticipate a shorter life expectancy.
Other considerations include having the discipline to invest the funds from a lump sum to be gradually used throughout retirement rather than spending the entire amount over a short period of time. Also consider your comfort with investing the lump sum and your willingness to take some risk to earn a reasonable return. A lump sum may be a good option if you need access to a large amount of money in the short term.
It’s good to strike a balance between fixed income streams that can provide more certainty and an investment portfolio that is more volatile with the potential to earn a higher return. If you have another pension consider a lump sum and if you don’t have a pension, a fixed income stream may add some stability to your financial situation
Another huge factor in the decision is the safety of your pension. Pensions offered by most public corporations are insured by the Pension Benefit Guarantee Corporation (PBGC) up to a limit of around $60,000 for a single life and $54,000 for a 50% survivor benefit. Unfortunately, state and local pensions are not covered under the PBGC. The pension administrator can tell you if your pension is insured by the PBGC and how well it is funded. Anything under around 80% is a red flag. If your pension is not insured and is not well funded it may be wise to take the lump sum.