Pension plans offering a lump sum to retirees is all the rage. GM has done it, Ford is doing it and other major corporations are doing it. For pensioners, the offer to give up a set monthly payment for life in exchange for a pot of money certainly gets their attention.
Before you take the money and run, there are a number of important things to consider.
First, beware of advisers. Financial advisers often cast themselves as objective service providers, but it is obvious they may have a financial interest in your decision. That is true of both stockbrokers and fee-only advisers. Seeking advice from a professional about taking a lump sum requires a great deal of trust. Asking the adviser to analyze your options on an hourly basis should help mitigate the inherent conflicts that clearly exist.
Second, your own mortality is not the only life you should consider. If you have reason to believe you are unlikely to live longer than expected, it is natural to consider the offer to cash out. However, if your spouse stands to receive benefits after you're gone, then your own longevity is of less importance. This is yet another example of when it doesn't pay to be inconsiderate of your spouse's needs.
Third, don't overestimate the investment returns you can achieve with your lump sum. The ultimate goal in choosing the lump sum is to be able to earn enough to fund your own distributions for life and still have some remaining to pass on to your heirs. That's one of the biggest draws with these offers.
However, ultimate success hinges on your ability to earn the right level of investment returns, in the right way. Remember, your former employer isn't getting out of the pension game for the fun of it. They know the cost and risk of disappointing returns. We've seen a few lump sum offers that imply you only need to make 3.5 percent to 4 percent on your money just to "match the performance" of the pension plan. That appears easy enough, but it certainly isn't the entire picture.
The volatility of your investment returns means you need to earn more to assure that you won't deplete the lump sum. Losses, especially in the early years, can significantly increase the probability of running out of money. Because of this, we estimate you need to make 1 percent to 1.5 percent more per year to be safe. Next, assuming you hire an investment adviser or buy a mutual fund, you probably need to add another 1 percent in management fees to the mix. This means you may need to earn about 6 percent per year to safely succeed.
This all begs the question, is it worth it to take the lump sum and assume the personal risk of managing your very own, privately managed, single-retiree pension plan?
The decision obviously is a big deal. In this world, an old-fashioned pension plan has a lot to offer and it is no surprise that prudently run corporations are sitting on the other side of the trade.
Jason P. Tank is a Chartered Financial Analyst and co-owner of Front Street Investment Management LLC, a local fee-only investment advisory firm. He encourages questions and comments about future columns. Contact him at (231) 947-3775, by email at email@example.com and at www.frontstreet.com