Note from the Editor: This is a guest post from long-time reader Horton. As an actuary, he’s the real pro in crunching numbers!
While corporate pension plans are on target to follow the way of the dinosaur, many people approaching retirement are still eligible for such a benefit. Pension plans offer a number of advantages for employees, preeminent among them is that the plan sponsor manages all investment, interest rate, and longevity risk. The only risk remaining for employees is inflation risk (except for those lucky few with an inflation-adjusted pension).
That said, there are a few challenges that employees face with pension benefits. One such challenge is how to decide when to take the monthly payments and in what form. Compounding the challenge is that you only have one chance to make the decision and you may be under time constraints to do so.
In this article, we will explore two helpful tools to evaluate your options.
To begin, let’s use the following example. Bob is single and 60 years old. He ran an estimate of his pension benefit assuming he starts it immediately. He received the following figures:
|Form of Payment||Amount|
|Single Life Annuity||$3,000 per month|
How does Bob choose between a lifetime payment and a pot of money?
The simplest way to help make the decision is to convert each option into the same unit of measurement. Bob’s pension election paperwork will likely include what’s called a relative value comparison, which attempts to show the value of the options on an apples-to-apples basis. We can also generate our own relative value comparison by converting the monthly payments into a lump sum, or vice versa.
But, how do we do that? The challenge is that you have to discount for both interest and mortality.
The easiest approach to evaluate pension payment options is to see what the insurance market will give Bob for the pension lump sum.
The Blueprint Income site offers a user-friendly resource to get insured annuity quotes. As shown below, the inputs are very simple. Bob just needs to provide:
- demographic information (e.g., date of birth, gender, state, and, if applicable, spousal information);
- the value of the one-time premium (i.e., his lump sum amount), funding source (assume an IRA in this case), and start date;
The results for the top three quotes as of Jun. 30, 2019 are shown below.
In all cases, Bob would get less from an insured annuity ($2,500 – $2,545 per month) than he would get if he took his pension benefit as an annuity ($3,000 per month).
That said, your situation may look significantly different. The purpose of the example is not to advocate that the monthly pension benefits are always the best option, but instead to provide a tool to help you determine what’s right for you and your family.
Annuity Factor Calculator
If you are interested in another tool and enjoy getting into the weeds, then the Annuity Factor Calculator from Society of Actuaries is a great resource. The inputs are a bit daunting, but, using Bob as our example, I will show how you can use it to compare the present value of monthly pension benefits to the lump sum option you are offered.
The Discount Rate is the interest rate used to determine the present value. We have a lot of reasonable options: Treasury rates, the expected return of our portfolio, or corporate bond rates. If I was a plan sponsor or a life insurer with a pool of lives, I would use a corporate bond yield curve. However, as an individual investor, I am more inclined to determine the present value of the annuity using a safer assumption. For our analysis, I will use the SEC yield as of Jun. 27 for the Vanguard Total Bond Market Index Fund of 2.58%.
The Annual COLA is the cost-of-living-adjustment (COLA) applied to the annual annuity payments. Bob’s pension does not have a COLA feature, so we will use 0%.
The Annuity Type is the form of payment. Bob is single, so we will select Single Life. If Bob was married, he could easily model a Joint and Survivor benefit by entering the Beneficiary Age, Beneficiary Gender, and the appropriate Survivor Benefit Prct (e.g., 50%, 75%, or 100%).
Bob will use age 60 for the Primary Annuitant Age and Benefit Commencement Age. If he wants to evaluate other starting dates, then he would change the Benefit Commencement Age but keep the Primary Annuitant Age unchanged.
He will select male as the Primary Annuitant Gender.
Last, we get to the complicated topic of mortality. I am going to keep this very simple, but you can refer to SOA’s mortality resources if you are interested. Long story short, there are two primary inputs – the mortality table that estimates mortality as of a particular point in time and the mortality projection assumption that estimates improvement in future mortality (i.e., people are assumed to live longer in the future).
Select the Valuation Year based on when the pension benefit will start – in our case it will be 2019.
For Mortality Before/After BCA, Bob will select the newly released Pri2012 tables (Pri2012_Total_Employee for Mortality Before BCA; Pri2012_Total_Retiree for Mortality After BCA). Again, many other viable options exist, but you probably don’t need to get bogged down in the details.
Select Generational as the Projection Method. By doing so we are assuming that the general population will continue to live longer in the future. Bob, at age 60, expects to live longer than his father did at age 60.
Select MP2018 as the Projection Scale to use the most recent data published by the Society of Actuaries.
For simplicity, I wouldn’t worry about any of the other inputs.
The inputs and outputs for the single life pension are shown below.
After updating the inputs and hitting Calculate, the SOA calculator gives the annuity factor on the top in blue. Multiply this number by 12 and again by the monthly pension number to get the present value. Write this number down and prepare the following table to compare different options:
|Form of Payment||Amount (A)||Annuity Factor (B)||Present Value (A) x (B) x 12|
|Single Life Annuity||$3,000 per month||17.7261||$638,140|
The end result shows that the present value of the monthly pension is greater than the lump sum using the inputs selected. This is consistent with what we saw in the insured annuity quotes as well, providing additional insight that the monthly pension may be the favorable option.
Bob should also consider the qualitative elements of this decision. Such as:
- What are his retirement income goals? If he wants a secure income for his lifetime, then the annuity may be the best choice.
- What if inflation increases significantly? His pension annuity does not increase with inflation, so that is a risk. Although, research shows that retirees’ cost of living tends to decrease as they age.
- What is his health status? If he expects that he will not live as long as the average 60-year-old, then he may prefer the lump sum. Bob can use the Longevity Illustrator to get a sense for life expectancies, and he could also adjust the Annuity Factor Calculator to use a mortality table that assumes better or poorer health.
- If he is not sure how to manage a lump sum to generate retirement income, then it may not be suitable to select the lump sum regardless of the present value.
Hopefully these tools provide a helpful method to evaluate pension payment options. Choosing a payment option may be a difficult decision, but consider yourself fortunate to have a pension benefit!
Note: Pension lump sums are generally determined using an interest rate and mortality basis prescribed by the IRS under code section 417(e)(3). The interest rates are published online and are developed based on high-quality corporate bonds (AA or better). Similarly, the IRS prescribes a unisex mortality table and a specific projection scale for determining lump sums. For both the interest rate and mortality assumptions, the annuity factor shown in this article was produced on a more conservative economic basis for an individual and is therefore higher than the annuity factor used to determine the lump sum. Nothing in this article should be construed as implying that the plan sponsor has determined the lump sum value incorrectly.