How To Tell If Your Employer’s Lump Sum Offer Is A Fair Deal - An Actuary-Splainer
This article appears at the following website: forbes.com
Did you get a notification from a former employer offering you the opportunity to cash out your future pension, or even a pension you’re collecting now or about to start, in exchange for a lump sum amount of money?
Are you trying to make sense of the numbers? Are you unable to shake a vague feeling that you’re being cheated?
Here’s a reminder: the federal government requires that private-sector employers use a standardized mortality table and a corporate bond rate assumption. In this sense, they can’t game the system. (If you’re a public sector employee, you’re out of luck. You have no such protections.) But bond rates go up and down, and mortality tables are adjusted from year to year.
At the same time, employers are permitted to use the employee’s age 65 benefit, even if early retirement or other benefits are available that are more advantageous to them.
But how does that play out for individuals in specific situations?
Here are some examples. All of these use the applicable mortality table for 2019 and the three-segment interest rates applicable to GE employees: 3.43% for the first 5 years, 4.46% for the next 15 years, and 4.88% afterwards, compared to alternate up-to-date mortality tables and discount rates, using the relevant actuarial mathematics.
Example 1: young blue-collar worker.
Our first worker is a 30 year-old blue-collar worker in average health, as blue-collar workers go. He has accrued a benefit of $500 per month payable at age 65. Using the standard assumptions and calculation methods (actual offers will vary slightly), his employer has offered him a lump sum payout of $13,613.
How can he tell if this is a good deal?
Because he is young, the three-segment interest rate doesn’t translate into anything particularly complicated – he wouldn’t collect his benefit for another 35 years, and his employer is calculating this based on the highest of these rates, plus about a 6% reduction in value for the chance that he won’t live long enough to collect the pension.
But at that young an age, a financial planner would advise him to invest in stocks, not bonds, to get a higher return. If he’s willing to invest in assets that are expected to generate a 6% return over his lifetime, then let’s say he has a “personal discount rate” of 6%, and discount the $500 monthly payments at this rate instead. As a blue-collar male, he also has a somewhat higher risk of dying before retirement than the IRS tables predict – about 8% instead of 6%.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
Combining these factors together, we can ask, how much is $500 per month starting at age 65 worth to this person based on his individual circumstances?
The math says: $8,660, plus the intangible value of having the benefit guaranteed for his lifetime. The employer’s lump sum payout offer is a better deal for him.
Example 2: white collar woman close to retirement.
Our second worker is a woman (reduced risk of death at any given age), a white collar worker (again, longer-lived on average), and is much closer to retirement, say, age 55. Taking into account both her years prior to and after she retires, she’ll want to invest in less risky assets, so she might want to use a “personal discount rate” of 4%. This means that the availability of $500 per month would be worth $60,633 to her now, plus the intangible value of the guarantee, but her employer would offer her an estimated $47,115. She should clearly keep the pension.
Now, I’ve referred to the value of the guaranteed element of an employer pension as “intangible.” It is true that it is possible to assign a monetary value to it; one easy way is to visit the website immediateannuities.com to get sample price quotes. In this case, to get a $500 per month income beginning in 10 years for a 55 year old woman in Illinois would cost $74,000, which is approximately the same as a discount rate of 3%. That’s a lot more than $47,115. But that math doesn’t produce the value to a given person, in the same way as the price difference between a $200 deductible and a $1,000 deductible car insurance policy doesn’t tell you how important the lower deductible is to you. Someone with other sources of guaranteed retirement income might not find this promise as important to them personally. In the same way, someone with no other income source than Social Security, and no other savings, might value having ready cash for unpredictable needs.
Example 3: an actual General Electric worker.
As I explained in my prior article, lump sum calculations are based on age-65 benefits. As soon as a pension plan participant is eligible for a special early retirement or other subsidy, it’s a whole ‘nother situation altogether. In the case of a GE worker otherwise eligible to begin benefits at age 60 without reduction, forgoing that to take a lump sum can amount to giving up 30% of your benefit value merely for the advantage of having a lump sum. Yes, for our hypothetical younger worker, this might still make sense, but for most workers, this is a large loss.
Of course, it should be said that GE’s early retirement subsidy benefit is significantly more generous than a typical plan. In many cases, the early retirement subsidy consists only of reduction factors that are lower than actuarial fairness would dictate; it’s also common to provide no such subsidy at all.
The bottom line
There is no single answer to lump sum offer decision-making that’s true for all participants, because there is no single “correct” discount rate (interest rate) to use to determine the value to a given participant of their future pension promise, and because mortality probabilities are different for everyone. (Heck, even in terms of pension valuations themselves, there are differences of opinion in whether the public pension method of using expected asset return, or the private sector method of corporate bond rates, or a yet more conservative risk-free rate, is correct.)
However, as a general rule of thumb, if your “personal discount rate” is higher than the rate your employer/former employer is required to use, it’s likely that you’ll be better off taking the money and investing it yourself, and if that rate is lower (because you’re closer to retirement and are taking fewer risks), your guaranteed monthly benefit will be worth more than the cash in hand.
Unfortunately, knowing what’s best requires expert advice beyond what most people have the capacity to seek out, and they’re left trying to make decisions based on their gut sense or intuition, which is of no particular help in a complex decision.