Deciding Whether to Take a Pension Lump Sum: The 2 Opposing Methods
The following is a guest contribution from reader and fellow blogger Grumpus Maximus, a 40-something U.S. military officer with 18 years of active duty service under his belt. Grumpus has recently realized that, with some minor lifestyle adjustments, he will reach Financial Independence by his military retirement point. With no formal education in finance, but being an expert in tracking his own money and a lifelong DIY investor, he is a keen observer of life for those who can expect to receive Defined Benefit Pensions. In this post he explores the thorny issues around taking a lump sum payout from a pension, and gives us two methods for making the determination: one for ‘thinkers’ and one for ‘feelers’…
I heard from the spouse of a soon-to-be pensioner recently. Mistrust was in the air. The couple was questioning the long-term viability of their pension, and the company that backed it. The spouse wanted to take a lump sum, but solicited the opinions of friends. Most of them encouraged taking the lump sum too. But I counseled caution, and encouraged the spouse to address the decision in a more holistic manner. I feared the couple would make a rash decision, miss that steady stream of income in retirement, and live to regret cashing in the pension.
The entire interaction reminded me of two important money lessons. The first is that major money decisions are extremely personal and fraught with emotion. So much so, that it often proves impossible to separate the objectively correct decision from what feels right. The second is that while most retirement planning decisions have some leeway for change, adjustments, or complete reversal, a few particularly hard ones do not. Whether or not to cash out a Defined Benefit Pension (DBP) as a lump sum is one of those irreversible decisions.
For those unfamiliar with the idea of a pension lump sum, it is the liquidation of an organization’s and/or its pension fund’s future financial obligation to a pensioner in the form of an immediate cash payout. Sometimes these payouts can be made into tax-advantaged accounts like an IRA. Many, if not most, pension systems offer pension lump sums. Since they do, it’s wise to ask "Why?". In short, a lump sum payment saves a pension fund money over the long run, making it more likely to remain solvent in order to meet future pension liabilities. By paying out a pension lump sum, a pension fund also transfers the future risk of running out of money to the pensioner.
The Problem With Pension Lump Sums
Believe it or not, in the U.S. at least, the government regulates how to calculate pension lump sums. However, as this linked article from Forbes.com points out, the calculations work in favor of the pension funds making them, not the recipient of the pension lump sum. Part of this is due to regulations which allow pension funds leeway within the rules for lump sum calculations. The U.S. government exacerbates the problem by providing counterproductive data which pension fund administrators must use when calculating lump sums. For instance, the lump sums offered to female pensioners use the same life expectancy data as male counterparts. That’s not fair since females statistically live longer than males.
The Forbes article links to a pension lump sum spreadsheet designed by the author to calculate the "real" value of your pension lump sum in today’s dollars based on more accurate life expectancy data and U.S. Treasury rates. It’s a little complicated, but worth the time if you’ve never bothered calculating this value. I can’t attest to whether it calculates the Total Dollar Value (TDV) like I do in Part 4 of the Pension Series, or if it simply tweaks the weaknesses in the government’s prescribed lump sum methodology. Either way though, if tabulated correctly, it gives you a value to work with that will be higher than the lump sum offered.
Despite the fact that a lump sum is a losing mathematical proposition, people will still consider taking the lump sum for any number of reasons based on their personal situation. Those reasons may range from pure want to true need. In some rare cases where inflation plays a role, the math may even make sense. Other pensioners may simply not realize a lump sum comes at a discount (for the pension fund) based on the conditions I described above.
As I found out in the recent exchange, emotion may compel some people to take a lump sum no matter what. No amount of logic or math can convince them otherwise. For them, the decision is personal and emotional. They might not trust their company to pay. They may not believe the pension fund will remain solvent. Or, they may believe they can manage the money better themselves. Cashing out is, of course, their prerogative. However, for everyone else considering a pension lump sum, it’s my hope they will at least apply some rigor to their decision-making process.
A Word on Biases
Since I run a blog whose moniker is "Where Financial Independence and Pensions Meet to Create a Better Retired Life," you’d be correct in assuming I am more sensitive than most to the idea of cashing out a DBP. I believe it requires serious consideration of all available information. DBPs are a rare breed these days. Depending on the features, DBPs can potentially provide a secure financial baseline in retirement which is hard to otherwise replicate.
In fact, blogs like Darrow Kirkpatrick’s spend a lot of time describing and analyzing alternative methods for building such a financial baseline in retirement. This is due to the demise of DBPs in the U.S. private and public sectors starting in the 1980s. Outside of government circles, DBPs are simply uncommon these days. Therefore, cashing out a DBP as a lump sum is a decision that should not be taken lightly.
My study of the intersection between pensions and the FI community leads me to believe that in the U.S. a high proportion of the few remaining career fields which provide a DBP require some sort of sacrifice. That sacrifice may take the form of a low paying and thankless public or private sector job; the monotony of working an assembly line; or the blood, sweat, and tears required to serve in the police, fire, or military. Thus, given that DBPs are so rare, and require such sacrifice, I’ve written an entire series of articles dedicated to valuing various aspects and features of DBPs. I did this primarily to enable potential pensioners to determine if striving and sacrificing for their DBP is "worth it." It’s a decision point I’ve dubbed the Golden Albatross.
However, the analysis required to navigate one’s Golden Albatross moment also lends itself incredibly well to the considerations involved in a pension lump sum decision. In fact, I’ve developed two different methods to assist in the decision-making process. One is a logic-based exercise designed to walk a person through the decision by considering the relative value of their pension in comparison to their reason(s) for potentially cashing out. I designed the other method to provide a Rough Order of Magnitude (ROM) for the amount of money a person would lose by taking a lump sum.
The Grumpmatic Method
Although I doubt anyone will ever confuse it with the Socratic method, the Grumpmatic Method is my thought experiment for making a relatively logical lump sum decision while still allowing for emotional considerations as well. I liken it to building a scale in your mind which balances an objective valuation of your pension on one side against the desires, wants, needs, or fears motivating you to take the lump sum on the other. I developed this method for the less mathematically inclined, who (like Mrs. Grumpus) need to feel their way through decisions as much as they need to think through it.
I don’t mean that as an insult. Some people are "thinkers," and some are "feelers." Opposites attract and the world needs both. Therefore, the Grumpmatic Method should feel intuitive for anyone who’s read my entire Pension Series up to this point because I’ve addressed many of the issues on both sides of the scales already.
Let’s discuss the objective side of the scale first. For the objective side of the scale, I recommend utilizing my list of the five most valuable pension features identified in Part 3 and 6 of the Pension Series. The inclusion of these five features in a pension makes it objectively more valuable than those without. Those features are:
- A short vestment period (possibly not germane to a lump sum consideration, depending on the pension)
- Initial pension amounts (what I call the Initial Dollar Value) calculated using formulas with high-income averages and percentage multipliers
- Payments which start immediately upon retirement
- Entire pension amounts which adjust annually using a Consumer Price Index-linked Cost of Living Allowance (COLA)
- Pension subsidized healthcare
If you are lucky enough to have a pension with all five features, then congratulations are in order because you have the Cadillac or Mercedes Benz of pensions. You can objectively weight your pension as "more valuable" on the Grumpmatic scale. Conversely, the fewer of these features in your pension, the less valuable it is. Thus, the less you should weight your pension on the objective side of the Grumpmatic scale.
Ultimately I would say if your pension possesses three of the five features, you have a "valuable" pension. If the pension has one or none, your pension is "less valuable." Play around with those labels as you see fit. They are not set in stone. In fact, depending on your personal circumstances, some of the features may be more valuable to you than others. For instance, pension subsidized healthcare is one of those features which many people would probably place high on the "valuable" list, to the point where it may outweigh all other considerations.
Speaking of outweighing other considerations, which lump sum motivating desires, wants, needs, or fears should you place as a counterbalance on the other side of the Grumpmatic scales? I recommend starting with fear for your pension’s safety. As I explain in Part 1 of the Pension Series, understanding the likelihood of your pension fund failing to meet its future financial obligations is key to determining whether or not staying at your pensionable job is "worth it." It only makes sense that it would prove fundamental to making a lump sum decision as well.
Fortunately, I discuss the factors to consider when determining the future safety of your pension in Part 1 of the Pension Series. The article provides what I think is a good foundation for determining how heavy to weight the fear that your pension won’t be there at some point in the future, and therefore the desire to take the lump sum.
What else could go on the counter-balance side of the Grumpmatic scales? If your pension does not have some sort of inflation-linked COLA, I believe it’s worth considering the devaluing effect of inflation on your pension. I discuss inflation’s nefarious effects on your pension to varying degrees in Parts 3, 4, and 5 of the Pension Series. Certainly, a rampant inflation scenario like the U.S. faced in the 1970s would quickly destroy the value of any non-inflation-linked COLA pension.
Yet, how likely is that? As I point out in Part 3 of this series, the average inflation rate stands at 3.22%, and on a macro scale has fallen steadily for decades. Furthermore, since 2007 the inflation rate has averaged only 2%. Thus, while not unimaginable, the conditions for rampant and unchecked inflation seem pretty far off (as of November 2017).
Hopefully, by now you get the point of the Grumpmatic Method. There are any number of items you could consider as a counter-balance to the five objective valuable features. However, some are more legitimate than others. Pension safety and inflation, legitimate. The desire to buy a little red Corvette, not so legitimate. Rent one for a week every year instead. You can thank me for it later (I like beer). Ultimately, once you figure out all your criterion on both sides of the scale, you will need to determine which side outweighs the other. Hopefully, you find it a useful and helpful thought exercise.
Grumpus Maximus in Mathemagic Land
Anyone remember the Disney cartoon from which I riffed the above section title? My 7th-grade math teacher showed the cartoon to us because he thought the scene where Donald Duck shoots pool using geometry lessons was cool. Unfortunately, I’m not about to take you on a groovy adventure to a world of mathematics, wonder, and shooting pool. No, I chose the section title because the calculations below really are more mathemagic than mathematics. In other words, don’t let the equations below fool you and don’t fall in love with the numbers. They are more art than science, so use them as a guide.
With that said though, I didn’t simply make this stuff up. As I demonstrated in Part 4 of the Pension Series, calculating the Total Dollar Value (TDV) of your pension in today’s dollars is possible. In fact, I believe you can get a fairly accurate understanding of exactly how valuable your pension is by doing so. However, the TDV calculations require you estimate your lifespan, and possibly the future inflation rate, depending on the features of your pension. Since TDV is used in some of the follow-on equations below which include other estimates, a level of uncertainty builds into the final value below fairly quickly. This is why I refer to the outcome as a ROM (Rough Order of Magnitude) value, vice the absolute value of the money lost by taking a pension lump sum. Enough with the caveats though, let’s get to the calculations.
In Step 1 you estimate your Total Pension Value (TPV) by adding the TDV to the estimated value of any Other Post-Retirement Benefits (OPRBs, see Part 6 of the Pension Series).
- Total Pension Value (TPV) = Total Dollar Value (TDV) + Value of any OPRBs
In Step 2 you subtract the Lump Sum Value (LSV) offered at retirement from the TPV to get the estimated amount of money you will lose by taking a lump sum. This is what I call the Lost Dollar Value (LDV). Remember, TPV is the total value of your pension over an estimated lifespan in today’s dollars. For reasons explained towards the beginning of this post, your LSV is always going to be less. Which means you will always have some sort of LDV. Hopefully, it is a small number, but don’t expect it to be.
- Lost Dollar Value (LDV) = TPV – Lump Sum Value (LSV)
Finally, in Step 3 you can choose to adjust your LDV to account for the likelihood of the pension fund defaulting or declaring bankruptcy. Maybe you want to get super nerdy and use something like Bayes’ Theorem to model the probability of this happening. If there is enough data available, it would certainly buy down some uncertainty within your final ROM. Whichever method you use, express it as the decimal equivalent of a percentage (0.0 through 1.00). Plug it into the right-hand portion of the equation below, run the calculations and you should have a ROM for the Adjusted Lost Dollar Value (ALDV) for your lump sum.
- Adjusted Lost Dollar Value (ALDV) = LDV – [LDV × (% likelihood of DBP fund failure)]
Let’s run one example to see how this works. Say I’ve calculated my pension’s TDV as $1.5mil over my estimated lifetime in today’s dollars. Subsidized healthcare is the main OPRB that comes with my pension. I estimate it has a value of $750K over my lifetime. Thus my TPV is $2.25mil.
- Step 1: $1.5mil (TDV) + $750K (OPRB) = $2.25mil (TPV)
Now we’ll pretend that the LSV offered by my pension fund is a cool $1mil. Thus I stand to lose $1.25mil in payments and medical benefits if I cash out.
- Step 2: $2.25mil (TPV) – $1mil (LSV) = $1.25mil (LDV)
Finally, I determine my pension fund isn’t managed well and is underfunded. After reading Part 1 of the Pension Series, I place a 45% chance the pension fund will run into major problems, and my pension will somehow be reduced or eliminated. Therefore I decide to adjust the LDV based on my belief.
- Step 3: $1.25mil – [$1.25mil × (.45)] = $687.5K (ALDV)
As you see from the Step 3 calculation, the higher the estimate of trouble for the pension fund, the larger the discount or adjustment to the LDV. Of course, if you work in the U.S. and have a private or a union-administered pension, ALDV completely ignores the potential for the Pension Benefit Guaranty Corporation (PBGC) to step in and continue making some sort of pension payments. However, as I point out in Part 1 of the Pension Series, despite the PBGC being a U.S. government-backed insurance agency whose sole purpose is to insure private and union pension funds against failure, the PBGC itself is severely underfunded. Thus, if they step in to bail out your pension, you should expect a reduction in your payments. I will leave it to your discretion to determine how to effectively represent that in the equations above.
Clear as Mud?
So far, no word from the spouse of the soon-to-be pensioner with regards to their decision on the lump sum. Honestly, the spouse didn’t really appreciate my counter-trend commentary in which I counseled caution. My suspicion is they took the lump sum. Obviously, I’m partial to a thorough examination of the pros and cons of the decision to cash in a DBP and take a pension lump sum. In fact, I cringe at the thought of people making such an important and irreversible decision without due consideration. I hope they at least considered the issue thoroughly.
From my point of view when someone takes a lump sum, they leave money on the table. Ultimately, that’s OK as long as it’s a deliberate and well thought out decision. Take or leave the methods I describe above. I provided them for consideration just in case you lacked a method for thinking about the problem. Depending on your preferred method for solving complex, interrelated, and emotional topics, one method might appeal more than another. My preference would be to run the mathemagic numbers. Mrs. Grumpus would prefer the Grumpmatic Method. However, neither of us will find ourselves in that position because my pension doesn’t come with a lump sum option. If yours does, I don’t envy you, but I sincerely hope you make a well-considered decision.
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