Evaluating a Pension Plan Offer
A popular corporate strategy known as “de-risking” involves buying out employee pensions. By shrinking the size of a pension plan, the company can reduce the associated risks and costs and limit the impact of future retirement obligations on current financial performance.
About half of workers with pensions can now choose to take their money in a lump sum at the time they retire.1 Moreover, 47% of corporate pension plans surveyed by benefits consultant Aon Hewitt planned on making lump-sum offers to vested former employees in 2015 or had done so in recent years.2
What’s good for a corporation’s bottom line may or may not be in the best interests of plan participants and their families. For most workers, there are clear mathematical and psychological advantages to keeping the pension.3 Even so, the lump sum could provide financial flexibility that could benefit some individuals.
Crunch the Numbers
A lump-sum payout transfers the risks from the pension plan sponsor to the participant. Individuals who opt for a lump sum must then manage that money and determine for themselves how much risk to take in the financial markets.
The lump-sum amount is the discounted present value of an employee’s future pension, set by an IRS formula based on current bond interest rates and average life expectancies. Often the amount is not enough to replace the pension income given up, unless the investor can tolerate exposure to stock market risk and is able to achieve decent returns over time.4
A pension’s lifetime income may be more valuable for women than for men because women tend to live longer, but gender is not considered when calculating lump sums. In their buyout offers, companies may not include the value of subsidies for early retirement or spousal benefits, the latter of which could be a major disadvantage for married couples.5
Window of Opportunity
A lump-sum payment might make sense for a person in poor health or someone with little cash in the bank for emergencies. Someone who is able to live comfortably on other sources of retirement income might also benefit from a buyout offer, especially if the funds are rolled into a traditional IRA. Pension payments end when the plan participant (or a surviving spouse) dies, but funds held in an IRA could be preserved and passed down to heirs.
Pension payments (monthly or lump sum) are taxed in the year in which they are received, and cashing out a pension before age 59½ may trigger a 10% federal tax penalty. Rolling the lump sum into an IRA enables a worker to postpone taxes until withdrawals are taken later in retirement. IRA distributions are also taxed as ordinary income, and withdrawals taken prior to age 59½ may be subject to the 10% federal tax penalty, with certain exceptions. Annual minimum distributions are required starting in the year the account owner reaches age 70½.
It’s also important to consider the health of the company’s pension. The “funded status” is a measure of pension plan assets and liabilities that must be reported annually; a plan funded at 80% or less may be struggling. Most pensions are backstopped by the Pension Benefit Guaranty Corporation, but retirees could lose a portion of the “promised” benefits if their plan fails.6
The prospect of a large check might be tempting, but cashing in a pension could have costly repercussions for your retirement. It’s important to have a long-term perspective and an understanding of the trade-offs when a lump-sum option is on the table.