The 12 Factors To Consider When Offered A Lump-Sum Pension

(Forbes) General Electric (GE) recently announced they had frozen their defined benefit plan and were offering lump-sum pension payouts to about 100,000 retirees. GE will also discontinue making pension contributions after 2021. This follows a similar action by Ford to freeze their defined benefit pension for their retirees. A Ford executive recently commented that although they no longer actively report internally on these figures, over the last few years, the take-up rate for a lump sum payment would bounce around between a third to a half. The recent average hovers around 40%. As pension liabilities loom, coupled with relaxed rules from the IRS on pension freezes, many more companies will likely freeze existing pensions and offer lump sums.

Companies freeze their plans to reduce future pension liability accruals. In GE’s case, the pension freeze will reportedly save $8 billion on the pension deficit and reduce corporate debt by $6 billion. The lump-sum payout moves the liability off the balance sheet forever, so any future market downturns are not borne by GE for those who take the lump-sum.

What is a defined benefit plan? Simply put, it’s a pension plan in which the employer guarantees a monthly payment to the retirees under certain conditions and rules. GE may offer a retiree a pension of $5,500 per month for life and offer alternative methods of payment, like a reduced pension to the retiree with a survivor pension to a surviving spouse. The payment is guaranteed, regardless of how long the retiree (and spouse) live, regardless of market conditions. A lump-sum is a form of pension payout that calculates the present value of future payments at a prescribed interest rate. The calculation is like a mortgage loan: The lump-sum is the value of the mortgage, the pension payments are the equivalent of the mortgage payments, the term of the loan is the life expectancy of the retiree, and the interest rate is the rate approved by the IRS. A $5,000 monthly pension, depending on the age of the retiree, might have a lump-sum value of about $990,000.

The decision is ‘what would you rather have: $5,000 a month for life, guaranteed, or $990,000 now, but you’re on your own?’ To make this decision, there are at least 12 factors retirees need to consider:

  • What is the age of the retiree? The younger you are, the bigger the prospective lump sum. This will add another layer of complexity because tax brackets vary based on a variety of factors including retirement income versus working income and filing status, single or married filing jointly.
  • What is the marital status of the retiree? A married couple generally has longer cash flow needs.
  • What is the relative health of the retiree? The spouse? The longer the joint life expectancy, the better the monthly pension looks.
  • What is the gender of the retiree? The spouse? Women live longer than men, but the actuarial tables used for pension purposes employ a unisex calculation.
  • What legacy wishes does the retiree have? (e.g. leave excess funds to children, grandchildren, charity). Monthly pensions almost always terminate on the death of the surviving joint pensioner. Lump-sums can provide residual value.
  • What are the retiree’s other sources of retirement income? (e.g. Spouse’s pension, investment income, Social Security [retiree and spouse], rents, jobs, ) What other retirement assets does the retiree have? (e.g. §401(k), IRAs, Roth IRAs, life insurance, annuities, and other investments)
  • What is the necessary retirement cash flow for the retiree? (e.g. living expenses, debt service, medical, ) A regular fixed flow like pension and Social Security may be adequate to cover the necessary expenses, freeing other assets for future costs or legacy.
  • How important is the flexibility of withdrawals? (Is the spouse working? What about Social Security or the spouse’s pension?) A lump-sum allows significant flexibility of withdrawal subject to the Required Minimum Distribution (RMD) rules or potential early distribution penalties if younger than age 59 1/2. This can dovetail nicely into Social Security claiming strategies or coordination of withdrawals from other assets.
  • What income tax bracket is the retiree in now, and what bracket might they enter after the age of RMD? Distributions from lump-sum pensions and other pre-tax retirement assets must generally begin no later than April 1 of the year following the year in which an individual reaches age 70 ½.
  • What is the retiree’s risk tolerance? This is a very important question. In a defined benefit plan, the plan (and company) assumes the investment risk. In a lump sum, which is typically rolled to an IRA, the retiree assumes the investment risk.
  • What is the retiree’s anticipation of future inflation? Most monthly pensions do not take inflation into account. With a lump-sum, a retiree can adjust for inflation in withdrawals and investment allocation.
  • What is the retiree’s investment knowledge or willingness to delegate investment management? Defined benefit plans are typically professionally managed with low expense ratios.

Overall, every lump-sum decision is unique to the retiree. Everyone’s situation and circumstances are different. A person in poor health with children may choose a lump-sum, while a fiscally conservative, healthy couple may opt for the monthly pension. In our experience, we've found that about 60-65% of the retirees we counseled retained their monthly pension.

A few other points:

  • Lump-sum calculations are based on a blend of interest rates. The lower the rates, the higher the lump sum. Here’s a real-life example: In August of 2018, the blended rate for a 60-year old was 4.16%, with a $5,000 per month pension generating a lump-sum of $949,704. In August of 2019, the blended rate for a 61-year-old (one year older) was now 3.08%, with the same $5,000 per month pension generating a lump-sum of $1,041,029.
  • Many retirees are approached by individuals selling annuities as an alternative to the lump-sum. In general, selling an annuity (the monthly pension) to buy another annuity (a commercial annuity) can result in higher costs to the retiree.

Bottom line: Be cautious when making the lump-sum decision, as there are a lot of factors that will affect the outcome. Get a second opinion, and carefully consider how the decision may affect all your assets. If you’d like a free copy of a White Paper on this topic (for another company that previously froze their pension plan), drop me an e-mail. It covers additional issues, like PBGC insurance, and includes a worksheet to help analyze a lump-sum offer with an advisor.

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