General Electric (GE) recently announced that after several years of disappointing results, it would freeze pension benefits for about 20,000 U.S. workers. It will also offer lump-sum buyouts to another 100,000 former employees who have yet to reach retirement age. GE had already canceled pensions for new hires beginning in 2012. The latest move is an even more aggressive effort to "stop the bleeding." The pension plan was underfunded by $27 billion as of year-end 2018, and GE estimates that the changes will reduce pension liability by $5 to $8 billion.
These cuts are humbling for GE, an industrial and financial conglomerate that boasted a rare AAA credit rating as recently as 2009. But they are typical of a multi-decade shift by major employers away from "defined benefit" (i.e., pension) plans in favor of "defined contribution" (i.e., 401k) plans. Between 1986 and 2016, the number of firms offering pensions declined by 73%. Most employees today are investing for retirement “on their own,” a daunting prospect for those with limited financial education.
Still, quite a few people in the workforce today have accumulated at least some pension credits with a former employer. Many will be offered a lump-sum payout instead of these promised pension benefits. For those weighing such a decision, here are seven critical issues to keep in mind:
1. A pension is an annuity. Both products pay a fixed monthly amount for life. These payments are based (in part) on average lifespans among men and women in the broad population. Therefore, if you have a shorter-than-average life expectancy (i.e., due to a health condition), you may want to accelerate your benefit by taking a lump-sum payout.
2. Time is your friend (but inflation is not). Younger workers are more likely to benefit from a lump-sum payout, because they may have 20+ years to re-invest the proceeds before their retirement. Moreover, because pensions pay a fixed dollar amount, inflation will erode the purchasing power of these payments over time (the longer you must wait to receive your benefits, the less they are worth in today’s dollars).
3. Shop around. Since pensions resemble annuities, the latter can be a useful price comparison tool. Online calculators (such as this one from Schwab) allow you to research the cost of an annuity that would replicate the payment features of your pension. If the cost of the annuity is much higher than the lump sum offered for the pension buyout, you may be getting short-changed. Remember, just because a buyout offer is on the table doesn’t mean you have to accept it.
4. Consider your legacy. Are you concerned about leaving money to heirs? Do you have a much younger spouse? If so, a lump sum buyout is likely the better option. Pension payments end at death (some allow a reduced payment to a surviving spouse). However, a lump-sum buyout can be rolled into an IRA and invested over your full lifetime, with any remainder passed down (tax-deferred) to your designated beneficiaries.
5. Know yourself. Are you extraordinarily risk-averse? Does following the stock market cause you anxiety? Are you concerned about your risk of cognitive decline as you age? If the answer to any of these questions is “yes,” then you may want to consider maintaining your pension as a source of guaranteed income in retirement.
6. Don’t ignore credit risk. Is your company’s pension plan fully funded? Is the company itself financially healthy? Pension payments are only “guaranteed” to the extent that the plan (and its parent company) remain solvent. If the employer goes bankrupt, there is a good chance that pension benefits will be cut. Be mindful of that risk, if you decide to remain in the pension plan.
7. Don’t forget about taxes. Often, employees treat pension buyouts as “found money.” But cashing a lump sum check and spending the proceeds could involve substantial tax consequences—potentially pushing you into a higher marginal tax bracket for that year. If you accept a pension buyout, the best course is to roll the funds over directly into an IRA account, where they can continue to grow tax-deferred. This option gives you the most control over your future tax liability.
Deciding whether to accept a lump sum payment today--versus a more distant promise of lifetime income upon retirement—is a complicated question, highly dependent on personal circumstances and some unavoidably subjective assessments. But thinking through the issues above should offer a solid foundation for the decision.
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