If you have a pension, your employer will generally give you a choice in retirement: buyout or payments. It is important to consider this carefully.
In general terms, many people make this choice based on the expected returns over the entire lifespan. If you accept and invest the buyout, what can you reasonably expect in terms of portfolio returns? How will this expectation compare to your guaranteed income if you accept monthly payments?
For example, let’s take a 65 year old person. She earned a pension of $1,850 a month in retirement, but her employer instead offered her a $200,000 buyout early in her retirement. Here’s how to approach the problem.
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Retirement context
Pensions are a form of employer-sponsored retirement plan. They are different known as a “guaranteed benefit” pension.
With a pension, upon retirement you receive a series of fixed payments for life from your employer. Generally, these are issued on a monthly basis. You pay taxes on this money, just as you would with ordinary income. These payments are considered part of the compensation you earn during your working life, meaning your employer cannot legally adjust them after the fact. The only way to stop making these payments is to resort to insolvency, in which case a federal court agency known as the Retirement Benefits Guarantee Corporation ensures your payments up to a maximum amount.
In the mid-20th century, pensions were an important form of employer-paid retirement. This was partly due to the strength of union bargaining at the time, with workers tending to prefer the ease and security of a pension plan. Today, they are massively disadvantaged by private employers because of their significant and unlimited cost. A pension plan means that employers pay not only for their current employees but also for their former employees, for as long as they all live, which gets expensive quickly.
As a result, many of the private employers that offer a retirement plan have begun offering a buyout option. When you retire, you can make a choice. Either take your pension as is and receive payments for life, or accept a one-off initial payment at retirement.
Should you do a buyout?
The big question for a retiree is: should you take the buyout? The answer will depend on what you want to achieve and how you can expect to compare returns.
From the point of view of achievements, there are broadly two ways of analyzing this question:
A net worth approach is generally an estate planning measure. Ultimately, if you don’t necessarily need it for income, what gives you the most wealth to pass on to your heirs?
The lifestyle approach is the most common and focuses on retirement income. Basically, if you rely on this money for your income, what gives you the highest standard of living?
From there, the question becomes how you will manage your investments and how long you should expect to live in retirement. Very generally speaking, you will need three numbers:
The latter feature is a feature of some pensions, in which they increase every year to take into account inflation. You’ll also want to consider less tangible things, such as your ability to manage money and a budget, as well as an investment portfolio.
A fiduciary financial advisor can help you weigh the trade-offs between retirement options. Talk to a financial advisor today.
Wealth-Driven Returns
Once you have defined your goals, the next step is to look at potential returns. If you focus on wealth, the math is:
If you invest your monthly income, will it grow more than if you invest the buyout? Which approach will leave more in your wealth?
Here, for example, we have either a monthly payment of $1,850 or a buyout of $200,000. Let’s say you invest this money in an S&P 500 growth fund, with an average annual market return of 10%, and you don’t have a COLA. Based on SmartAsset investment growth calculatorIf you retire at age 67 and live to age 87, in the upper average range for a retiree, you could expect a final portfolio of:
Over 20 years, you would have more savings thanks to the monthly pension. On the other hand, let’s assume a younger lifespan, say between 67 and 77 years. Your final portfolio could be:
Redemption – $518,748
Pension – $379,234
If you have reason to expect a retirement lifespan of only 10 years, your monthly payments will not have enough time to catch up with the redemption. You will probably leave a larger estate with the buyout.
Income-Driven Returns
Most households will make their plans based on income. If you have a retirement plan, it is likely that you will live off of it and Social Security benefits. In this case, the calculation becomes a little more complicated:
Pension payment and withdrawal from wallet
Depending on how you choose to invest and your overall life expectancy, will you earn more money each month from pension payments or withdrawals from your portfolio? This problem introduces several other areas of hypothesis, because you are not investing solely for long-term growth. You invest for a mix of growth and security, while making withdrawals.
So the question is: what rate of return would you need for your portfolio income to exceed your pension income? Let’s run this for a few different hypotheses using the Schwab calculator:
Lifespan 20 years, COLA 2%: ROI 12%
At retirement age, the average life expectancy is between 84 and 87 years. So, if we assume you receive your pension for 20 years and that pension has a 2% annual cost of living adjustment, your $200,000 portfolio would need an annual return of 12% to generate more than $1,850 income per month.Lifespan 20 years, COLA 0%: ROI 10%
Here we assume the same average lifespan of 20 years (from 67 years to 87 years), but without adjustment for the cost of living. In this case, your $200,000 buyout would need a 10% rate of return to generate more than $1,850 in income per month.Lifespan 10 years, COLA 2%: ROI 4%
But suppose you have reason to believe that you will die relatively young for a retiree. With a 2% cost of living increase, but a 10-year lifespan, you’ll only need a 4% return for your portfolio to generate at least $1,850 per month.Lifespan 10 years, COLA 0%: ROI 2.17%
Finally, say that you have reason to believe that you will die relatively young and that your pension will not have a cost of living increase. In this case, a 2.17% rate of return will generate $1,850 in monthly income.
The result is that life expectancy is largely determining. The longer you live, the more your monthly payments will accumulate compared to your large initial purchase.
For more detailed projections tailored to your specific situation and goals, consider consult a fiduciary financial advisor.
At age 67, the average life expectancy extends to the mid-80s. It largely depends on gender and health status, but the average retiree should to wait for live another 16 to 20 years. Even a modestly long lifespan means living more than 20 years off your savings. In this case, the pension would be much more valuable than the buyout. Your portfolio would need consistent, market-beating returns just to cover the pension income.
On the other hand, if you have reason to believe that you will die relatively young compared to other retirees, the buyout becomes more valuable. For someone only living into their mid-60s, even a portfolio of bonds will likely generate more income than a pension.
The essential
Should a buyout be carried out? It depends on a lot of assumptions and details, but generally speaking, it’s generally better to collect a monthly pension unless you have reason to believe that your life expectancy is unusually short.
More resources
Investing for retirement is complicated, and that includes lump-sum investing. If you have a windfall, like a pension buyout, here’s how to think about managing it.
A financial advisor can help you develop a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool connects you with up to three licensed financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one is best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.
Keep an emergency fund on hand in case you face unexpected expenses. An emergency fund should be liquid – in an account that doesn’t have the risk of large fluctuations like the stock market. The tradeoff is that the value of cash can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare the savings accounts of these banks.
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