In this video from the Motley Fool Answers podcast, Alison Southwick and Robert Brokamp welcome Sean Gates to the show as they answer listener questions.
Here, they ponder two alternatives: take a lump sum payment now or the long-term annuity that pays out at a later date. To get to the bottom of this question, they also have to break down the health of the pension plan.
A full transcript follows the video.
This podcast was recorded on Dec. 13, 2016.
Alison Southwick: The next question comes to us from Warren in Alexandria. Hey, just down the road somewhere. "My former employer has temporarily offered me the opportunity to receive a $43,000 lump-sum payoff now instead of a pension that is projected to pay me about $550 per month starting in September of 2029. I do enjoy managing my family's accounts but recall you saying on the podcast that the retirees with the most guaranteed incomes are the happiest. I am wondering about why I got this offer in the first place. Is the pension fund shaky? Am I better off simply keeping the pension, which is a single life annuity or taking the lump sum?"
Robert Brokamp: Well, first of all, anyone who's going to get this sort of classic defined benefit pension should stay on top of their plan. Every plan has an annual report and it will give the funding status. So he can look into that and get an idea of whether this is happening because the plan is underfunded. There's also something called the Pension Benefit Guaranty Corporation (PBGC) that also has some of that information.
To really do the analysis for his question, if I were him I would run some numbers, and I will give you an example, here, and he would run various scenarios. Let's say if he earned 5% a year, his $43,000 or so could grow to about $82,000 in 2029. If he had that amount of money now and bought an immediate annuity, it would pay him about $450 a month. And I found that from ImmediateInnuities.com. You can get a quote. So just looking at those numbers, it looks like actually keeping his pension would result in a bigger payout as long as the pension is safe and it's going to be there in the future.
That said, if he gets this money now, he does have freedom with it. He can use it now if he wants to. It will be transferred from the pension into an IRA, so there will be some rules about how he can access it. And if he earns higher than 5%, it actually might end up benefiting him more by delaying it.
Sean Gates: And I think the only perspective I would add, here, is that the only modifier to the calculations that Bro did, that you want to consider, is what does that $500 and change monthly benefit do to your income tax bracket, because a lot of the times you don't necessarily account for how an increased retirement income might affect your retirement tax bracket. Whereas if you take the lump sum and invest it, you could potentially stretch that out further. So there's another layer on taxes that you could look at.
There's actually a great study that came out where they showed that the typical person who has the option to take a lump sum would require almost a 9% rate of return annualized to achieve the same benefit that they would get on a monthly basis from the pension corporation. I don't want that to be a stat that people use to not take a lump sum, because sometimes that makes sense, but it's difficult to recreate that pension. And you're taking the risk on yourself, whereas if you leave the pension and just take the income, that risk of investing it to provide that benefit is on the company. You don't have to take on that risk.
Southwick: Talk a little bit more about pensions, though. When he talks about whether the pension fund is shaky, is that a serious concern? Do pension funds go belly up all the time and then people who are counting on them just get nothing in retirement?
Brokamp: That's what the PBGC does. It is an insurance, basically. It's sort of like the FDIC for pensions and it will pay that. The problem is there's a limit on how much you'll get, although based on the amount he's giving here, he's below that limit. But also, the PBGC is severely underfunded, so that's going to be another problem coming down the road [with] pensions, because a lot really are severely underfunded. That's a real question about what will happen in the future.
My answer for him is if he's a solid investor and he appreciates having more control over the money, go ahead and take the lump sum. If not, and the pension is on solid ground, it might be better to leave it.
Gates: We do this sort of analysis for clients all the time, and it is surprising how many pensions are underfunded. The stat that the PBGC, itself, is underfunded goes to speak to how often these companies are going ...
Because the PBGC is actually funded by, more or less, premiums that the pension companies pay to backstop that fund. It's not a federal organization funded by federal dollars. It's run by the federal government, but it's funded by premiums, mostly, from the pension companies themselves. And so normally they're like 80% funded, at best, so it just gives you a sense of how severely underfunded some of these can be. The state of Illinois, I think, is at like 65% funded.
Brokamp: It's really one of those things that doesn't get talked about a lot, but it can be a huge issue down the road. Illinois is an example we've heard about. Detroit and other places, too, with severely underfunded pensions. What's going to happen? Either those folks are not going to have the money they were counting on, or taxes have to [be raised] significantly and a lot of people are going to be like, "You're raising my taxes to pay for these people who are retired?" It's going to be very interesting.