How to choose between different pension purchase options

On By Yukito

Once upon a time, many employers offered retirement plans to employees. Pensions are a financial instrument designed to replace part of an employee’s salary in retirement, providing them with a reliable income for the rest of their life.

Today, pensions have fallen out of favor with many employers due to cost of living, longer lifespan, and compliance obligations. For this reason, many employers try to purchase retirement benefits for employees in the form of a lump sum or various lifetime income benefits.

If you are in a situation where your employer is offering you a buyout, it is extremely important to learn how to evaluate the different retirement buyout options.

Intention

Because pensions are designed to provide income stability in retirement, it is extremely important to re-evaluate your retirement goals and income needs when faced with a pension buyout. If you don’t have 100% saved for retirement, you’re missing out on a degree of financial security by not earning an extra few bucks to have fun today. I have seen people who are not prepared for retirement take out a lump sum pension and use the funds to build a swimming pool in their backyard, which was a bad financial decision.

The good news is that buyout options can replace some of your lost financial security. Which buyout option is best for you depends on your risk tolerance and level of discipline.

Evaluation of buyout options

Let’s assume we have a 41-year-old married investor who is facing a retirement buyout. He was given three options:

  1. Get a flat $150 a month from now until you die.
  2. Receive a flat $1,080 per month from age 65 until you and your spouse die.
  3. Pay a lump sum of $40,000 today.

The best way to assess the value of each option is to take the net present value of each option, adjusted for inflation and return on investment. An investor’s risk tolerance will make a big difference in which option makes the most sense.

Let’s assume our investor is relatively conservative and expects both he and his spouse to die at age 95. If he received a lump sum, he could put it in cash, money market funds, certificates of deposit, bonds, or some other combination. Assuming an inflation rate of 3% and an average investment return of 4%, here is the net present value of each option:

  1. $150 a month is worth $41,116.
  2. $1,080 a month is worth $91,812.
  3. A lump sum of $40,000 is worth $40,000.

In this case, from a purely financial perspective, the investor would be much better off choosing option 2. If the investor had a higher risk tolerance, the net present value of the retirement cash flows would change dramatically. Let’s assume this investor has a growth goal and would invest in a portfolio of approximately 80% equities and 20% fixed income. If we expect this investor to earn an average ROI of 8% and we hold all other assumptions constant, the numbers will change as follows:

  1. $150 a month is worth $23,912.
  2. $1,080 a month is worth $25,326.
  3. A lump sum of $40,000 is worth $40,000.

The lump sum option is the clear winner in this case. By the time an investor reaches age 65, he or she will have $258,150 to spend in retirement. However, conscious investment choices require discipline.

If you feel you have a high risk tolerance but may not invest the funds once you receive them, reach out to a professional to help you with investing, or consider one of these income options. You should also transfer your pension distribution to another retirement account to avoid taxes and penalties in the year of maturity. If you are tempted to cash out, I once again advise you to consider the income option to enforce discipline.

Additional notes

Some factors not included in the previous examples for ease of calculation. The future taxation of income is almost impossible to predict, but varying taxation may slightly change the calculations. Additionally, mortality at the age of 95 was assumed. According to the Social Security Administration’s mortality tables, the average 41-year-old is expected to live an additional 40.15 years to die at age 81. Moving away from the average mortality rate would make each of the income options less attractive and the lump sum option more attractive.

Application

When faced with a retirement buyout offer, you should carefully evaluate your options to ensure long-term financial stability. Each surrender option – whether it’s a lump sum or lifetime income – comes with its own set of risks and rewards. By evaluating the net present value of each option and taking into account your risk tolerance, investment discipline and retirement goals, you can make an informed decision that is consistent with your financial needs. Additionally, consulting with a financial professional can provide valuable insights and help you navigate the complexities associated with a retirement buyout, ensuring you make the best choice for your future.

This informational and educational article does not constitute tax or financial advice and should not be relied upon. Your unique needs, goals and circumstances require personalized attention from tax and financial professionals, whose advice and services will take precedence over any information contained in this article. Equitable Advisors, LLC and its affiliates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or suitability of any portion of the content linked to in this article.

Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI and TN), and also offers annuity products and insurance through Equitable Network, LLC, which does business in California as Equitable Network Insurance Agency of California, LLC). Financial professionals may only transact business and/or respond to inquiries in states in which they are qualified. Any compensation Ms. Jones may receive for publishing this article is obtained independently and entirely outside of her resources at Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-7197192.1 (10/24)(exp. 10/28)