If you have a pension, your employer usually gives you a choice upon retirement: buyout or payout. It is important to look at this carefully.
Broadly speaking, many make this choice based on expected lifetime returns. If you take the buyout and invest, what can you reasonably expect in terms of portfolio returns? How will that expectation compare to your guaranteed income when you make the monthly payments?
Take, for example, a person who is 65 years old. He or she would have earned a pension of $1,850 per month at retirement, but his employer instead offered a $200,000 buyout at the beginning of retirement. Here’s how to look at the problem.
A financial advisor can help you assess your retirement options and integrate them into your retirement plan. Make a match with a fiduciary advisor today.
Context about pensions
Pensions are a form of employer-sponsored retirement plan. They are also known as a guaranteed benefit pension.
With a pension, you will receive a series of fixed lifelong benefits from your employer upon retirement. Normally these are issued monthly. You pay income tax on this money, just like with regular income. These payments are considered part of the compensation you earn during your working life, meaning your employer cannot legally adjust them afterwards. The only way to stop these payments is through insolvency. In that case, a federal agency known as the Pension Benefit Guaranty Corporation insures your payments up to a maximum amount.
In the mid-20th century, pensions were an important form of employer-issued retirement. This was partly due to the strength of union negotiations at the time, as workers preferred the convenience and security of a pension plan. Today, they are overwhelmingly unfavorable among private employers due to significant open-ended costs. A pension scheme means that employers pay for not only their current but also their former employees for as long as they all live, which quickly becomes expensive.
As a result, many private employers offering a retirement plan have begun offering a buyout option. When you retire, you can make a choice. You take your pension as is and receive lifelong benefits, or you accept a one-off advance payment upon retirement.
Should you take a buyout?
The big question for a retiree is: should you make the buyout? The answer depends on what you want to achieve and how you can compare returns.
From a performance perspective, there are basically two ways to analyze this problem:
A net worth approach is generally a wealth planning measure. Basically, if you don’t necessarily need it as income, what gives you the most wealth to pass on to your heirs?
A lifestyle approach is most common and focuses on retirement income. In short, if you depend on this money for your income, what gives you the highest standard of living?
From there, the question is how you will manage your investments and what lifespan you should expect when you retire. Very roughly you need three numbers:
The latter is a feature of some pensions, where they increase annually to take inflation into account. You’ll also want to consider less tangible inputs, 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 tradeoffs between retirement options. Talk to a financial advisor today.
Wealth-oriented returns
Once you’ve set your goals, the next step is to look at the 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 ensures that more is left in your assets?
For example, here we have a monthly payment of $1,850 or a buyout of $200,000. Let’s assume you invest that 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’s investment growth calculator, if you retire at age 67 and live to age 87, at the high end of average for a retiree, you can expect a final portfolio of:
In 20 years you would have more savings from the monthly pension. On the other hand, let’s assume a younger lifespan, for example from 67 to 77 years. Your final portfolio could look like this:
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Redemption – $518,748
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Pension – $379,234
If you have reason to expect a retirement life of only ten years, your monthly payments won’t have enough time to catch up with the buyout. When you buy out, you will probably leave behind a larger estate.
Income-oriented returns
Most households will make their plans around income. If you have a retirement plan, chances are you will live on it and Social Security benefits. In that case, the math gets a little more complicated:
Pension payment versus portfolio withdrawal
Based on how you invest and your overall life expectancy, will you make more money each month from retirement benefits or from withdrawals from your portfolio? This issue introduces a few more assumptions, because you’re not just investing in long-term growth. You invest for a mix of growth and security, while also making withdrawals.
So the question is: what return would you need to ensure that your portfolio income is better than your retirement income? Let’s run this for a few different assumptions using Schwab’s calculator:
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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 the pension has a 2% annual cost of living adjustment, your $200,000 portfolio would need an annual return of 12% to make more than $1,850 per month to generate income. -
Lifespan 20 years, COLA 0%: ROI 10%
Here we assume the same average lifespan of 20 years (ages 67 to 87), but without adjustment for the cost of living. In that case, your $200,000 buyout would need a 10% return to generate more than $1,850 per month in income. -
Lifespan 10 years, COLA 2%: ROI 4%
But let’s say 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 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 living expenses will not increase. In that case, a 2.17% return will generate $1,850 per month in income.
The result of this is that life expectancy is largely decisive. The longer you live, the more your monthly payments will accumulate relative to your large prepayment loan.
For more detailed projections that fit your specific circumstances and goals, consider consulting with a fiduciary financial advisor.
At age 67, the average lifespan extends into the mid-80s. This depends greatly on gender and health, but an average retiree could be expected to live another 16 to 20 years longer. Even modest longevity means you can live off your savings for more than 20 years. The pension would then be considerably more valuable than the redemption. Your portfolio needs consistent, market-based returns to meet retirement income needs.
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 who won’t reach their mid-seventies, even a bond portfolio is likely to generate more income than the pension.
It comes down to
Should you do a buyout? That depends on a lot of assumptions and details, but broadly speaking you’re usually better off with a monthly pension payment unless you have reason to believe you have an unusually short life expectancy.
More resources
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Pension investing is complicated, and that also applies to lump-sum investing. If you have a windfall, such as a pension buyout, here’s how to think about managing it.
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A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that isn’t at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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