Imagine this scenario. You work for a company that has previously committed to provide you with a traditional defined benefit pension after you retire, but now wants to lock in its costs for those benefits by offering you a choice. You can:
- Take a one-time lump sum payment, representing the present value of the pension benefits it has made on your behalf, which you can then use to invest for your retirement through your own Individual Retirement Account (IRA).
- Take an immediate annuity, in which your employer takes the lump sum and sets you up to receive monthly payments for life beginning now from an annuity provider it selects based on whatever annuity option you select.
- Let it ride, where you may keep your defined benefit pension.
To be frank, the main reason that your employer is offering you these options is because they don't know how much it is going to cost them to provide you with a guaranteed benefit like a traditional pension. Defined benefit pensions were developed at a time when pension investment managers could count on relatively risk-free investment options for decent returns, which have increasingly become difficult to identify over the last decade.
For your employer, falling short means having to take money away from things that benefit the business, like new investments that help generate more revenue to keep the business in business going forward.
For you, choosing your company's pension buyout offer means taking on the risks that they otherwise would have to take on your behalf. That risk was always there, but now will no longer be hidden from you.
But the question is now this: can you do a better job in managing that risk and your retirement than your employer? And to answer that question, we've built the following tool, which you can use to work out how well your employer thinks they would be able to do. Just enter the indicated information that your employer will have provided to you in our tool below, and we'll run some quick estimates of the rates of return your employer believes they can obtain.
If you're accessing this article on a site that republishes our RSS news feed, click here to access a working version of our tool.
In our tool's results above, the average rate of return that you would need to beat represents the rate that your employer would have to obtain in investing the amount of your lump sum payment today to be able to provide your monthly pension payment after you've retired, without having to add any extra money to make up any shortfalls.
To put that rate of return in some context, the average rate of return for investments in the S&P 500 of any duration is 9.4%, which does not account for the effects of inflation over time. Then again, neither does your employer's promised pension payment.
And of course, stock market returns can be volatile, especially in the short term. See our Remapping the S&P 500's Performance Since 1871 tool for a quick summary of the best, worst and average rates of return ever provided by investments in the S&P 500 stock market index and its predecessor indices and components to get a sense of just how volatile that might be over the period of time between the present and when you might retire.
Meanwhile, the immediate annuity's interest rate is the annualized rate of return that your employer can obtain in taking the lump sum and setting you up with monthly annuity payments. While this would be a sure thing, where the payments will last as long as you live, or as long as the annuity option you select lasts, it also will never be adjusted to account for the effects of inflation over time.
As a final note, this tool applies to defined pension benefits that are fully funded, where your employer regularly sets aside sufficient funds to ensure its pension plan can fully satisfy all its obligations to the company's future retirees. For underfunded pensions, and particularly public sector pension plans, you would need to also consider just how seriously underfunded your pension plan may be in making your choice, as your pension plan's manager may not be capable of generating the kind of returns on its investments that will be needed to keep the plan from going into default when it comes to making its full promised payments to you in retirement.
Labels: investing, personal finance, tool
Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:
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