What's a better financial choice when you retire: A lifetime pension, paid monthly, or a single, lump sum of money to invest today? It's a decision most retirees have to make, one way or the other.
Only large, old-line companies offer traditional pensions as a choice. But even at companies without pensions, you face a similar decision about the payout from your 401(k) or other retirement accounts: Should you invest the entire sum in mutual funds and other assets, or use part of it to buy a pension, in the form of a commercial annuity?
This question is in the news because of actions recently taken by General Motors and Ford. Formerly, their salaried workers had to take pensions with monthly payouts when they retired. Now, the companies are asking them whether they'd like to swap their monthly pensions for large lump sums.
Getting rid of these pensions will save Ford and GM money by clearing these future obligations off their books, says adviser Leon LaBrecque of Troy, Mich., who has analyzed both plans. For retirees, the decision is less clear-cut. Many will be better off keeping their lifetime pension payments (I'll talk more about this below). Others can make better use of the lump sum. They'd roll it into investments in a tax-deferred individual retirement account (IRA).
If offered a choice like this, at any company, how much would you get, if you skipped a pension in favor of its equivalent in cash? The answer depends on your age and current interest rates. The company assumes that you will invest the lump sum in an IRA at a specific annual rate of return. (The total, effective rate isn't usually disclosed in the offer but you can call the company and find out.)
If you indeed earn that much money on your IRA investments, and if you make monthly withdrawals equal to what your pension would have paid, the lump sum is supposed to last for your expected lifetime (and that of your spouse, if you had chosen a joint pension).
As an example, take Tom, 65, who currently receives a Ford pension of $3,210 a month. His life expectancy is 19.14 years. Ford might offer him $503,554 to buy him out, LaBrecque says. If he invests that sum in mutual funds yielding 4.6 percent after fees, and withdraws $3,210 a month, the money is supposed to last until Tom is 86. What happens if he is still alive at 87 is Tom's affair, not Ford's. He might be fine, provided that he has other money on hand. On the other hand, he might be broke.
What should Tom, or any other retiree, consider when making a decision like this? Here's what you need to know: