If you have a pension, your employer will usually give you a choice at retirement: buyout or payments. It’s important to review this carefully.
In broad terms, many make this choice based on expected lifetime returns. If you take and invest the buyout, what can you reasonably expect in portfolio returns? How will that expectation compare with your guaranteed income if you take the monthly payments?
For example, take an individual at 65. They have earned a pension of $1,850 per month in retirement, but their employer has offered a $200,000 buyout at the start of their retirement instead. Here’s how to look at the issue.
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Pensions are a form of employer-sponsored retirement plan. They are otherwise known as a “guaranteed benefit” retirement.
With a pension, upon retirement you receive a series of fixed payments for life from your employer. Typically, these are issued on a monthly basis. You pay income taxes on this money, as you would with ordinary income. These payments are considered part of the compensation that you earn during your working life, meaning that your employer cannot legally adjust them after the fact. The only way to stop making these payments is through insolvency, in which 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 a major form of employer-issued retirement. This was in part due to the strength of union bargaining in that era, as workers tend to prefer the ease and security of a pension plan. Today they are overwhelmingly disfavored by private employers due to their significant and open-ended cost. A pension plan means that employers pay not only for their current but also their former employees, for as long as they all shall live, which gets expensive quickly.
As a result, among private employers that offer a pension plan, many have begun offering a buyout option. At retirement, you can make a choice. You either take your pension as-is and receive payments for life or you accept a single, up-front payment at retirement.
The big question for a retiree is, should you take the buyout? The answer will depend on what you want to achieve and how you can expect to compare returns.
From an achievement standpoint, there are broadly two ways to analyze this issue:
