Are you one of the 17% of of Americans who still have a pension at work? Are you one of the 35% or more than has an old pension from a previous employer? Have you received a lump sum offer from a previous employer and want to know if you should take it? Do you currently work in a job with a pension and are trying to compare that against a job offer without? Do you have an option to stay in a pension or opt out for some other financial benefit? We’re going to explore these questions and provide a walk through of figuring out how much your pension is worth.
The availability of pension plans has declined since reaching its peak in the mid 1980s. This decline has coincided with two major events during that time frame: The introduction of defined contribution plans and an 82% drop in long term interest rates from the peak of pension plan offerings in 1985 until today. This meant an alternative retirement benefit became available at the same time pension plans has become exponentially more expensive.*
I was fortunate to start my career in 2003 with a company that maintained a pension plan throughout my employment and I can access the pension at the age of 65. I considered leaving the company numerous times and had to figure out exactly what the pension was worth vs moving to a company that did not provide a pension. Subsequently I’ve used that same math and analysis to respond to questions about people receiving a lump sum offer they are considering from a prior employer. I’ve not personally received a lump sum offer since retiring early, but expect to receive one from my company in the future.
Part 1: Calculating the Value of a Pension & Walkthrough
A pension is a promise of future payments from your employer based on your compensation and years of service. Those future payments have a value. Did you know you have the ability to recreate a pension of your own at any time? The product is known as a Single Premium Life Annuity. You provide an up front dollar amount to an insurance company and they can guarantee you income for your lifetime. What does this have to do with valuing a pension? Your pension is worth the same amount as what you’d have to turn over to an insurance company today to recreate your pension payments. Here’s the overview page from our friends at Charles Schwab about the product:
The pension is an asset of the employee/former employee. This also means the employer has a pension liability and why they will make a lump sum offer to exit that liability.
I’m going to complete the first sample walk through of valuing a pension using numbers similar to my actual pension calculations. I’m currently 37 years old and have earned a pension benefit of $2,000/mo at age 65. There is no cost of living adjustment in my pension and the $2,000/mo is based on me as an individual. The pension will have other variables like survivorship and early withdrawal options, but for simplicity we’re going to base this off of the individual benefit only.
I clicked on the calculator from the previous page and it brought me to the Schwab Income Annuity Estimator
Using this calculator, I chose the option of “Income To Last My Lifetime” and ask for an estimate based on $2,000/mo. Then I choose a start date of January 1st, 2047 and put in a date of January 1st, 1982. They ask you to choose a state because not all life insurance companies do business in all states, so there can be a slight variation in outcomes. I went ahead and used my prior state of residence in Texas for this example.
I input the variables then I click on the next button and get these estimates on the following page.
Schwab provides four different annuity estimates showing what I could pay today to recreate the $2,000/mo pension. I circled the first option, which is the most consistent with my current pension, $2,000/mo starting at age 65 for the rest of my life. The result is $161,811. If I wanted to further refine this, Schwab offers a phone number you can call and get an official quote.
Part 2: How and Why Do Employers Reduce Their Pension Obligations
The cost of pensions continue to increase. People are living longer, interest rates are lower, and the cost of providing pension benefits has increased. Many employers have taken action to curb these increased costs resulting in some plans are being eliminated, frozen, or redesigned. There are a number of options that employers are using to reduce these pension costs:
- “Freezing the Pension” – This usually means you will accrue no additional benefits after the moment it is frozen. New employees won’t be eligible and existing employees stop receiving benefits.
- Reducing benefits for new employees: New hires receive a lower benefit as of a certain date.
- Increasing employee contributions: The employer will ask all employees to contribute more through a payroll deduction to ensure the same level of payments. This situation is more common in pensions negotiated through collective bargaining and governmental pensions.
- Lump Sum Payout: The employer will offer a current or former employee an amount in exchange for a mutual termination of the pension benefit.
- The Employer Sells the Pension Liability to an Insurance Company.
At times you may have a choice in what happens to your pension at times you may not. The overall decline in pensions means you may be faced with changing employers and going between jobs that are and are not pension eligible.
Part 3: The Lump Sum Offer:
Lump sum offers are becoming more common, especially for former employees that are vested in a pension or employees of a company/municipality that are no longer offering a pension. Usually an employee will find out about a lump sum offer through a letter offering to pay you an up-front amount in exchange for terminating your pension. This amount can be rolled directly into an IRA and the individual now assumes the investment risk instead of the pension plan.
If you have a private sector pension and you receive a lump sum offer, there are rules involved relating to the minimum amount employers must offer. This offer will likely be less than the full market value of the pension. If the employer wanted to just transfer the liability at its current value, they can do so by transferring it to an insurance company for an amount similar to the replacement annuity.
Lets look at a sample lump sum offer: A 40 Year old individual was given three offers from a previous employer.
A) $45k lump sum (into an IRA) now
B) $200/mo for life starting now
C) $1000/mo for life starting at 60
This was a nice surprise to get in the mailbox but created some choices. Using Schwab’s calculator, I first model up the example of taking $200/mo starting today. Here are the results:
$57,444. Option B is interesting, an income stream worth $57,444 or take a $45,000 lump sum offer that the original poster can invest themselves. This means the lump sum offer was 79% of the value of the immediate annuity offer of $200/mo offer. Later on we’ll discuss other risks to consider, but let’s look at the second option, $1,000/mo for life starting at age 60.
$115,155. Now we start getting a glimpse into the former employer’s motives. They have a pension obligation that is $115,000 and they are attempting to entice the former employee with an offer that’s only around 39% of the cash value of the pension.
I’ve calculated a few different offers people have received and around 40% seems to be the minimum offer that can be made based on the current IRS tables. The replacement annuity is a current market rate while the IRS rates have some lag to them, so I expect the offers in 2020 will be higher. (note: If I have any readers who are actuaries, I would love to get more detail on the IRS segment rates to add)
Part 4: Evaluating a Pension vs. Non-Pension Job.
There were numerous times in my career where I considered moving from a pension eligible job to a non-pension eligible job. This can be a challenging decision, one compensation package includes money promised in 10, 20, or 30 years while the other offer compensation does not.
The most important thing to remember in this calculation is outside of being a federal government employee there is no guarantee you will have a pension benefit beyond next year. A private sector employer may eliminate their pension and a public sector employee (especially local/state) may see changes to their pension. Everyone’s situation is different and predicting a pension’s continuation of accruing benefits is like any other investment, making an educated guess about future probabilities.
I’m going to start with an example I faced in my career. Near the end of my career, each additional year I worked was worth around $150/mo in my pension starting at age 65. My company still offered a pension plan while most competing employers didn’t. I received an offer of employment from a company that didn’t offer a pension. I looked at all probabilities and decided to assume I would likely stay in my job for at least two more years and it is unlikely that my employer is going to make any changes to their pension in the next year. I was 35 at the time. How much was the next year of service worth?
I used the same calculator and modeled this based on a 35yr old and earning a pension benefit of $150/mo for the additional year of service. (Also a nice benefit to add an extra year of worked before calling it quits). Here are the results:
The pension eligible job is essentially $12,157 in compensation. All things being equal, the new job would need to provide this much in additional compensation to equal the benefit of staying in the pension for another year.
This is an easy example to use because I was already vested in my current pension and was only considering the first year of earnings. Many pensions require working a certain number of years before earning any benefit. If I were moving from a job that didn’t have a pension to one that has a pension, the math is similar but you must take other factors into account, such as the vesting period, the probability the pension will continue, and the risk the pension can/will pay out its promised benefits.
Part 5: Risk & Other Factors to Consider
Evaluating a lump sum offer or a pension eligible job vs. a non-pension eligible job is not just a mathematical equation. A pension is an investment and just like any other investment, you have to evaluate both its probability of performing in the future and how it should fit into your overall financial plan.
What is the performance risk in a pension? This is the risk that the pension plan may not be able to pay full benefits in the future. Some municipal plans have reduced benefits due to financial issues. Corporate pension plans are insured up to a benefit amount by the Pension Benefit Guarantee Corporation, a government run insurance fund setup to provide insurance against a pension plan failure. The corporate pension plan is insured by PBGC would pay based on this maximum guarantee table.
If you are in a municipal plan or have a private sector pension due that’s above the guarantee table, then you should take the next step and google your company/state/county/city’s name followed by the term “credit rating”. The results will end up returning a press release stating what the employer’s credit rating was in a recent review. If the credit rating is investment grade, the pension probably doesn’t have much performance risk. If it is below investment grade, there is likely performance risk. To understand what is/isn’t an investment grade credit rating, please refer to this guide on Investopedia.
What about continuation risk? If you’re evaluating a job with a pension plan vs. one without, one important consideration is what is the likelihood the company will continue their pension plan? Things you can look at are do competing companies in the industry have a pension plan? Has the company already made changes to their plan in the last few years? If you are looking to move into an employer with a plan, how long must you work there to vest in their benefits?
What type of investment is this similar to? A pension is an insured liability of a company or a general obligation of governmental entity. This means its risk is similar to investing in either a treasury bond or a municipal bond. I’ve often seen people respond to a lump sum offer and say “take it, you can earn more by rolling it into an IRA and investing that money in VTSAX”. That statement is actually saying “take more risk”. A corporate bond with insurance or a general obligation of a government is different than an equity index fund. Maybe it is appropriate to exchange a bond style investment for a sum you can roll into an IRA and invest in an index fund – However that is an individual decision based on a combination of the appropriate risk for the investor and the amount offered in a lump sum relative to the market value of the pension.
What about survivorship benefit(s)? One specific thing to explore in your pension plan is survivorship benefits that extend to a spouse. A lump sum offer could be passed along to heirs while the pension benefits likely disappear after the death of an employee and their surviving spouse. If you’re already well past financial independence, the lump sum offer could be more valuable for your estate planning.
What is an appropriate offer for a lump sum? This is a highly personal question depending on your personal financial position and health. I know in our situation, if we get a lump sum offer that gets above 70% of the market value of the pension, we would give some consideration to taking it to be able to take more risk with the funds. The pension currently serves as a nice bond-style allocation in our portfolio.
Pension plans are a valuable portion of compensation to employees who are covered by one. It is important to understand the value of that pension, what to do when/if you are presented with a lump sum offer, how to consider competing job offers, and what the other risk factors are involved in your pension. This is a highly personal decision for each individual.
Early Retirement Now: Social Security and Pensions
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*There are plenty of other reasons for the long term decline in pensions. Higher life life expectancy has increased by a couple of the years since the mid 80s. Specific pensions have failed that are included but not limited to poor management, poor plan design, unsustainable debt loads on companies (sometimes done through private equity ownership), and long term industry declines. I personally experienced the pain as a taxpayer when the City of Dallas’s Police & Fire Pension had to be resolved by the Texas State Legislature. There were no winners in an issue created from an unrealistic plan design combined with poor oversight of the investors.