Evaluating Pension Buyout Offers

There’s been a surge in Retirement Watch members telling me that they’ve been offered lump sums to buy out their pension rights. That’s no surprise. The number of employers making such offers greatly increased in recent years, according to research reported in The Wall Street Journal. About 22% of larger employers are expected to make such offers in 2015.

Those offers will be limited in the future. The IRS over the summer issued rules that basically prohibit plans from making buyout offers to those already retired and receiving benefits. But active employees still will receive them, and there still are offers on the table from before the new rule.

Pension buyout offers generally ask former employees or those nearing retirement if they want to give up the right to receive that monthly check for the rest of your life in return for one payment many times the monthly check.

The offers are coming now because law changed a few years ago. Employers now can offer lower lump sums in lieu of annual pension benefits. Many employers also want to remove the pension obligations from their books. Plus, the quasi-government agency that insures pension benefits raised the premiums it charges employers.

Here’s how to evaluate that pension buyout offer.

Other benefits. Your pension might have other rights associated with it. If you’re still working, there might be disability benefits or an early retirement subsidy. The pension also might have spousal or survivor benefits. The loss of these benefits often isn’t disclosed in the buyout offers, and the lump sum doesn’t include money to replace them. It replaces only a single life annuity.

You also should know if the pension is insured by the Pension Benefit Guaranty Corporation and, if so, the amount of the guarantee. If you receive a lump sum, it won’t carry such a guarantee.

Review any benefit publications or web sites available to you, and contact the employee benefits office to see if you are eligible for such benefits.

Determining the value. The lump sum often looks like a good deal compared to the smaller monthly annuity payment. But you need to compare apples to apples by taking a hard look at comparable numbers.

By accepting the lump sum offer you’d be giving up guaranteed lifetime income. So, determine how much it would cost you to replace that guaranteed lifetime income. Most private sector pensions aren’t indexed for inflation. You receive a fixed monthly amount for life. That makes the analysis easy.

Determine the lump sum you would need to buy the same guaranteed lifetime income from a private insurer. You can contact my recommended annuity expert, Todd Phillips of Phillips Financial Services at 888-892-1102. He’ll be able to tell you the lump sum the top-paying, financially-secure insurers will require for an immediate annuity to match your pension. Or you can go to a web site, such as www.immediateannuities.com, which will tell you the terms offered by the insurers they deal with. The odds are that you’ll have to pay the insurers more than the lump sum offered to receive the same guaranteed income.

You might not be retired yet. Let’s say you are 55 and the pension wouldn’t begin paying until 65. Then, your inquiry has two parts. First, you have to ask the insurers to estimate what lump sum you would need to give them at age 65 to pay a monthly amount equivalent to the pension. Second, estimate the rate of return you’d need to earn for the lump sum to compound to that amount by age 65.

Another way to evaluate the offer is to calculate how long the lump sum would last. Estimate how much you’d want to withdraw each month for spending. Then, estimate how long the lump sum would last at different investment rates of return at that spending rate. Another approach is to assume you’ll spend each month whatever the monthly annuity was going to be. Then, estimate how long the lump sum would last at that spending rate at different investment rates of return.

Conservative investors likely will find that their investment returns won’t be enough to allow the account to last for their life expectancy at a spending rate similar to the monthly pension. More aggressive investors might be able to sustain the payouts and even have something left for their heirs, but that assumes the markets cooperate and their actual results match historic returns. Bad markets would leave them worse off than conservative investors.

Evaluating the soft benefits. That brings us to an important and intangible factor. With the pension you have a guaranteed monthly income, assuming the pension fund doesn’t go broke or if it does your annuity is covered by the PBGC. With the lump sum you have the potential to earn a higher return, generating enough cash to replace the pension annuity and perhaps leave something for your heirs. But there’s no guarantee of either result. You might have lower investment returns and run out of money during your lifetime. By taking the buyout offer, you’re giving up the lifetime guarantee and taking the investment risk yourself.

With the buyout offer you’re also taking the risk of a long life. The buyout offer assumes you’ll live to average life expectancy. The lump sum might be more attractive if there are reasons to believe you will be among those with below-average life expectancy. But if you live beyond life expectancy, you’ll need higher-than-average investment returns or lower spending for the lump sum to last.

Taxes. When you receive the monthly pension payments, they likely will be fully taxable as ordinary income. You’ll have the after-tax amount to spend. A lump sum can be rolled over into an IRA without incurring immediate taxes. But you’ll owe taxes as money is distributed from the IRA. Or you might convert the IRA to a Roth IRA after the rollover and pay the taxes at that time. In that case, there wouldn’t be any taxes on future income and gains earned by the Roth IRA. If you take the lump sum directly instead of having it rollover over to an IRA, you’ll have to include the entire amount in ordinary income in the year it is received. Those are the most likely tax scenarios. If you have some after-tax contributions in the pension, the results might be a little different for you, because those won’t be taxable when you take them out.

Another tax factor is required minimum distributions. If you take the lump sum and roll it over to a traditional IRA, after age 70½ you’ll have to take the RMDs. This could deplete the account faster than you planned and increase your tax burden.

Evaluating a pension buyout offer requires you to consider a range of issues and take several different steps. The most important issue to keep in mind is that accepting the offer means shifting the risk of a longer life and lower investment returns from the pension plan to you. You’re taking responsibility for achieving adequate investment returns and managing the spending and also taking the risk you might live a very long life.

RW October 2015.