closeup of smartphone screen with words Pension Fund

What is a Pension Buyout? Our Pension and Wealth Management Advisors Explain

A pension used to be a common source of income in retirement, but today, many employers are shifting away from these plans and offering other options instead. Because of this, not all financial advisors understand the idiosyncrasies of these plans. Scarborough Capital Management does.

For example, what should you do if you’ve received a pension buyout offer from your company? The decision about whether to accept a pension buyout offer is not one to be made lightly. It’s important to understand the terms and the potential effects the offer can have on you, both pro and con.

At Scarborough Capital Management, pension analysis is one of our specialties. Our pension and wealth management advisors understand these unique retirement plans and are ready to help you understand your options.

 

Facing a pension plan buyout decision? Contact the pension and wealth management advisors at Scarborough Capital Management to see how we can help.

 

Pensions Versus Other Retirement Plans: Understanding the Backdrop

Defined Benefit Plans

To understand the stakes of a pension buyout, it’s important to know some facts about pensions compared to other retirement plans.

A pension is a retirement plan known as a defined benefit plan. “Defined benefit” means that the pension amount and payout is arrived at by a formula the company sets, which is known to both the company and its employees. The amount generally includes factors such as the employee’s salary and length of service.

The employer has the sole responsibility to make sufficient contributions over time, invest the money it contributes and help safeguard the assets so they are available to pay employees during their future retirement.

At retirement, employees with a pension receive a certain set sum, usually monthly and usually for life. The sum does not fluctuate with market conditions. The terms and age at which employees can retire and receive a pension are set by the company.

Companies set up pensions and administer them. Companies are responsible for investment risk and planning in a defined benefit plan such as a pension. If market conditions or investment conditions make it difficult to continue to pay the pensions, the burden is on the company to make up the shortfall, to continue to pay its pension obligations. In fact, that responsibility is one reason for pension buyouts: Companies would like to shed their risk.

Defined Contribution Plans

Over the last several decades, another type of retirement plan, called defined contribution, has become much more common. A 401(k), for example, is a type of defined contribution plan.

In a defined contribution plan, employees choose whether to contribute to their retirement plan and how much. While the employer may set up the plan, match contributions and choose the array of investment options from which employees choose, it is the employee who bears the investment and planning risk.

You, the employee, have the sole responsibility to make sufficient contributions over time, invest the money contributed and help safeguard the assets so they are available for you during your future retirement.

Poor planning or market volatility could cause your 401(k) assets to drop below a level you are comfortable with; that risk is borne by you. Any risk that you will run out of money in retirement is also borne by you.

Understanding a Pension Buyout

A pension buyout occurs when a company decides to offer its employees an immediate lump sum payment in lieu of having to pay a monthly amount to the employee during retirement for the rest of their life. This move relieves the company of any future financial liability that exists from operating the pension plan. If you take the lump sum, you will no longer receive a pension. It’s important to carefully weigh the pros and cons of these two moves.

Remember, just because you are offered a buyout does not mean you have to participate in it. You can choose either to remain in the pension plan or to take the buyout.

Remaining with the Pension: Pros and Cons

The pros of remaining with a pension can be significant, especially if your company is economically healthy. First, you are receiving a defined retirement benefit for life. This can offer the benefit of economic security: No matter what happens in the world or the financial markets, you will receive your pension. Second, you will continue to receive it without any worries about running out of money. Third, it provides certainty in forecasting your financial future. All of these pros are directly linked to the financial health of the company offering the pension.

A pension also saves you from having to make financial decisions. You do not have to make decisions about where to invest the money or what to do with a lump sum. People vary in their comfort level and risk tolerance when it comes to making financial decisions. If you don’t have a great degree of comfort, remaining in a pension can simply be a better psychological move for you, allowing you to sleep at night.

And the cons? Well, first, if your company is not economically healthy, your pension may be subject to risk. Companies that become bankrupt, for instance, no longer pay pensions. Other economic stresses or mismanagement can also cause the pension system to come under stress.

Most pensions in the United States fall under the Pension Benefit Guaranty Corporation (PBGC) in the case of the company’s bankruptcy. The PBGC pays benefits to qualified employees of bankrupt companies. The amount you receive from the PBGC may be less than if your company had survived economically and take a long time to receive.

Second, pension payments are promised by the employer for the rest of the employee’s life and sometimes the rest of the spouse’s life. A common concern with this is that the employee may not live long enough to receive the full value of the pension.

Third, many pension plans are not adjusted for inflation or tax increases, meaning that they will not be worth the same in 10 or 20 years as they are today, in terms of your standard of living.

Taking the Lump Sum: Pros and Cons

Should you instead take a lump sum? It may depend on your circumstances.

It’s prudent to consider your own spending habits. Some people become more prone to spending a large amount of money quickly if they are given access. If you fall into this category, a lump sum might pose some financial dangers for you. You don’t want to spend your nest egg all at once!

The lump sum option could also be a disadvantage due to the fact that a discount rate is applied. Meaning the lump sum amount is based on the present value of all payments due over your actuarial life valued as of the time you accept payment.

Why would someone want to even consider this option?

The lump sum may have advantages if you can combine the lump sum payout and your outside savings (e.g. IRAs, 401(k)s, etc.) to replace the employer’s projected distribution payments if you kept the pension.

Passing funds remaining from the pension on to children or charity is not possible with a pension plan; once you and your spouse have passed, the payment stream ends. With a lump sum, the assets belong to you. Therefore, they may be left to a spouse, other loved ones or charity after your death. Simply put, the lump sum permits you the freedom not only to direct where the money will go while you are living, but also after your death.

If you are in poor health or know that your life expectancy is not long, it may be more prudent to take the lump sum. A set amount for life may, in these cases, not be as advantageous to you as having a large amount of money relatively quickly.

It’s important to discuss these pros and cons, plus your preferences and the company’s outlook, with pension and wealth management advisors who understand how each decision will affect you and your overall financial plan.

Scarborough Capital Management is a nationally recognized specialist in the retirement plan arena, having advised thousands of individuals through the pension buyout process. We provide retirees and employees alike with actionable insight to help them make a decision for their specific situations.

 

New call-to-action