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Taking Your Lumps

Richard Connor

I’M ONE OF THOSE lucky folks whose employer had a traditional defined benefit pension plan. I worked in the aerospace industry, starting with GE in the 1980s. Various mergers led to us to become part of Lockheed Martin. Through these multiple sales and mergers, our benefits and pension plan stayed largely the same, though—to be honest—I didn’t pay a lot of attention in my early years and was only vaguely aware of the details. This lack of interest, however, changed dramatically later in my career.

After 26 years of service, my division was sold to a private equity firm. Lockheed and the firm that bought us were able to come to an agreement that kept our pension intact and active. Four years after the divestiture, however, our traditional defined benefit pension was frozen and replaced with a cash balance plan. At that time, a lump sum option was added, but its calculation was confusing and not consistently applied across all retirement scenarios. I realized the time had arrived to become much more familiar with the pension’s design and its various options. It was during this research that I became acquainted with a wonderful word: superannuated.

The Cambridge Dictionary defines superannuated as “old, and almost no longer suitable for work or use.” In the pension world, it might be rephrased as “highly paid employees whose current productivity doesn’t warrant their salary.” Many pension plans include a design feature to incentivize employees to retire early to help with this problem. Like these other plans, my pension plan had provisions for “early retirement.”

The plan had two distinct categories of “early retirement” that allowed an employee to receive a reduced pension as early as age 55. The first category was for employees with five years in the pension plan who voluntarily left the company before age 55. An actuarial reduction of approximately 8% per year was applied to the monthly annuity if you took your pension early. For example, employees in this category would receive about 35% of their full pension if they took it at age 55, instead of the 100% they’d receive if they waited until 65.

The second category was for employees who met certain service and age requirements, and therefore were eligible for an “early retirement supplement.” How did folks qualify? You needed to be age 55 or older when you left the company and been enrolled in the pension plan for at least five years. Alternatively, you could qualify—even if you were younger than 55—if you’d been with the company for 25 years and were laid off. With the “early retirement supplement,” an employee would receive significantly more—75% of his or her full pension amount at age 55 and 100% at age 60.

Why am I bothering you with all this? If you’re covered by a traditional pension plan, there’s a good chance that someday your employer will make you this offer: You can get your promised monthly payment—or you can get a lump sum right away. Many folks jump at the lump sum, which—if you don’t bother to run the numbers—can seem impressively large compared to the monthly pension payment.

I was offered the chance to take a lump sum payout a few years ago, when I retired. The lump sum was calculated at the standard retirement age of 65, and then reduced, depending on how old you currently were. The catch: The lump sum calculation didn’t include the early retirement supplement. To be fair, the plan administrator provided estimates of an employee’s pension, including a comparison of the present value for all the options.

My estimate at age 60 showed that the lump sum was worth about 65% of the present value of the monthly annuity, including the early retirement supplement. In my mind, this large difference made the monthly annuity the clear winner. I was happy to select it and help my employer with its superannuation problem. The lesson: It pays to thoroughly understand the details of your pension plan—and never assume the lump sum is always the better option.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles were Quiet Heroism and Think Bigger. Follow Rick on Twitter @RConnor609.

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james mcglynn
james mcglynn
2 years ago

I calculated my pension at age 60 versus age 65 on an excel spreadsheet and the totals didn’t cross till age 92! And that was with no rate of return assumption. Easy decision to take at 60. Just never know till you run the numbers.

David Abbott
David Abbott
2 years ago

In my case, I retired at age 69 and like Richard, I had the option of taking either the lump sum or the annuity. After discussing this with my wife, we jointly agreed that the lump sum was the better option because if we should die prematurely, the insurance company that issued the annuity would end up with a large gain and our children would receive no benefit. I’m also of the opinion that my financial adviser and I can manage the money just as well as an insurance company. Whether you take the lump sum or the annuity really depends upon personal circumstances and how much financial savvy you bring to the table.

David J. Kupstas
David J. Kupstas
2 years ago
Reply to  David Abbott

There are a couple of components to the decision. First, lump sums are required to be based on low interest rates, so there is a good chance you can invest and beat the underlying rate of return. The other component is how long will you live. The lump sum might be a great deal if you die at an “average” age, but if you live to be 115, the annuity might have been the better deal. Of course, none of us can know that at the time of election unless perhaps if you are in poor health at the time.

David J. Kupstas
David J. Kupstas
2 years ago

For about 13 years, plans have been required to provide a relative value disclosure. This is probably the present value comparison referred to above. The rule was passed because the average layperson has no way to evaluate if one form of benefit is actuarially fair compared to another. This is particularly true with lump sum payouts. While a plan may offer a subsidized early retirement benefit to encourage people to retiree, there is no requirement that the lump sum include that subsidy. It only needs to be actuarially equivalent to the normal retirement benefit. Human nature being what it is, many people would jump at the lump sum if there were no relative value disclosure to illustrate that it’s worth only 70% of the straight life annuity payable at that age. They might still jump at the lump sum even if the relative value disclosure is there, but that choice is on them. http://blog.acgworldwide.com/is-your-employer-cheating-you-on-your-pension-lump-sum

Langston Holland
Langston Holland
2 years ago

Present Value is the best financial evaluation tool I’ve ever come across and I’m very impressed that retirement plan administrator gave you those numbers. Unless mandated by law, I’d expect them to withhold that information to try to get as many people to bite on the lump sum as possible.

What interest rate did he use to “discount” the lump sum and monthly annuity? Is the annuity to be paid for life, or a specified number of years? Thanks!

Rick Connor
Rick Connor
2 years ago

The detailed PV calculation of each option only came in the “official estimate”, not on the tool the administrator provided. It was buried on page 20. Several of us had done some previous analysis and were able to get very close using the plan’s tool. The plan uses IRS 417e interest rates. The original plan formula calcualted a monthly annuity only; the lump sum was added at the time the legal plan was frozen and replaced by a cash balance plan. I think the company expected many folks to take the lump sum, but the company was full of engineers and scientists, many with long service, so the disparity in the lump sum calculation became fault well known. I took a annuity for life with Joint & Survival for my wife.

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