These “traditional” pension plans are referred to as defined benefit (or DB) plans – meaning that your benefit is defined as a determined amount. This benefit is usually based on a combination of your longevity in the job, plus your ending salary. You’re probably familiar with these computations: an example is a pension that is 2% per year of employment, multiplied by the average of your final five years of salary. So if you worked at a job for 25 years and your final five years’ salary average was $80,000, your annuity would equal $40,000 – which is $80,000 times 2% times 25 years. Often the calculations are more complicated, but that’s the gist of how they work.
In addition, your plan may also offer a cost of living adjustment, or COLA. With a COLA, each year the amount of your annuity payment is increased according to an inflation index such as the CPI, or a fixed rate such as 3%.
There are often other options to choose, such as the pension payout period. It might be for your lifetime (a “life annuity”), for you and your spouse’s lifetimes (a “joint and survivor annuity”), or over a set period of time, like 10 or 20 years (a “period certain annuity”). Quite often, unless there is a survivor option (such as a joint and survivor annuity) or a set period of time (like the period certain annuity), upon your death there will be no residual benefit from the plan. It is because of this that many folks look with favor upon the final option: the cash-out and rollover.
Cash Out and Rollover
Most often these DB plans also offer an option to receive a cash value settlement for the plan. The amount of the settlement is a discounted value of the future cash flows (the pension payments) that you could expect to receive. For example, the pension mentioned above (the $40,000 per year payment, with no COLA) for a 62 year old retiree might have a cash-out value of $400,000. This may seem like a pretty nice amount of cash. However, this is where some folks act too quickly. (Actuaries, if you’re out there, I just picked some numbers out of the air. I don’t know if they’re realistic or not. Forgive me!)
I get it – $400,000 in hand seems like it would be worth more than a future promise to pay $40,000 a year. Because, what happens if you die two years into the plan? As mentioned before, unless you have a survivor element in the pension plan, there will be nothing left for your heirs. There’s a lot more to consider than just the amount of the payout and your lifespan.
Things to Consider
It’s important to look at the provisions of the plan and all of the available options in order to determine what’s the best route to take. Each of the various payout options (life annuity, joint and survivor, period certain, etc.) needs to be examined to understand how the cash-out payment is calculated. (This is where it pays to know and work with a financial advisor.)
As you look at the various pension alternatives, consider them in comparison to one another. Sometimes the company subsidizes the survivor benefit to a degree, making a joint and survivor annuity more beneficial than either the single life or the cash-out option. In addition, sometimes for an early retirement option, the pension itself (over all payout options) is subsidized by the company, or “sweetened” to make retirement more attractive to the potential retiree.
As mentioned before, your health and the health of your spouse (as it impacts your lifespan), plus your other financial resources and lifestyle goals need to be considered as you look at the plan options. You also want to consider the financial strength of the company whose pension you’re considering, as well.
Example
Going back to our example: the cash-out payment of $400,000 should be considered against the other pension payout options. The single-life payout was calculated at $40,000 per year for your life. What if the joint and survivor pension payout option was calculated at $36,000, and your spouse is also age 62? This means that you would instead receive $36,000 over your life and the life of your spouse if you predecease him or her. First of all, which option is a better deal? And secondly, is one or the other better than the lump sum cash payout?
We have to make some assumptions when calculating the values of these options. According to actuarial tables, using a joint and survivor option will statistically result in more years of payments, even if the two lives are the same age. Therefore, when comparing a single life annuity to a joint and survivor annuity, we assume that the joint and survivor annuity will be paid out for a longer period of time.
Using a 5% discount rate, the value of the joint and survivor payout is worth approximately 10.8% more (in present value) than the single life annuity. In other words, if you bypass the joint and survivor option, you’re giving up that potential 10.8% of extra value. Another way to look at it is that you’re giving your company a gift of the extra value by not choosing the J&S option.
Either of the pension options are also better than the cash payout – from a strictly financial standpoint, as long as you live to whatever the projected mortality age is for your plan (I used 82 for the example). This is because the rate used to discount the present value of your future cash flows was 5%. This means that you’d need to get a return of something more than 5% from your lump-sum cash payout during that time frame in order to break even. Keep in mind that this 5% is a guaranteed rate – as long as you live long enough.
Of course, if your health is poor (or you have a family history of life-shortening health problems), you may benefit by taking the lump sum, for the “bird in the hand” benefit. However, if you happen to live longer than the actuarial tables project, you might be in the unenviable position of outliving your funds.
These are some of the issues you need to consider. This has been a very rough example but it should help you to understand the importance of looking before you leap.
It’s often very attractive to choose the cash-payout option since there are many inherent problems with the defined benefit pension plans. But you shouldn’t make the decision willy-nilly. It pays to examine the numbers closely, and if necessary hire someone to look at the numbers with you. You should know what you’re possibly giving up with each choice versus the alternatives.