Pensions

Give me your answer, fill in a form
Mine for evermore
Will you still need me, will you still feed me
When I'm sixty four?
--The Beatles

Throughout much of the 20th century, an attractive employee benefit offered by corporations was the pension. In its most common form, pensions are monthly payments to employees after they retire. The payments kick in at a certain age (often age 65) and last until the employee dies.

Pensions are known as 'defined benefit' plans because employees know exactly how much they are supposed to get on a monthly basis. The amount of the payment, which in most cases remains constant through the life of the benefit, is calculated based on age, earnings, and years of service.

My first employer offered a generous pension benefit. Employees became 'vested' in the plan after 5 years of service. When I left the company after 12 years of service, I took with me the promise of a modest monthly pension that I could begin collecting at age 65. There is an option to take those payments earlier, beginning at age 55, but for a lower monthly amount.

Until recently my intent was to wait until age 65 before drawing the full pension amount. Since I'm still working, there is no acute need for a supplemental income stream. Moreover, the monthly payment appreciates 8-9% annually if I wait until age 65 before collecting it. Few fixed income investments that I know of currently possess that kind of return profile.

However, a couple weeks ago I received an offer from the pension plan for what is known as a 'lump sum buyout.' Instead of paying the monthly annuity until I die, the plan is offering me a single, relatively large payment today. If I accept the lump sum offer, then this legally relieves the pension of any future payment obligation to me.

Why would a pension plan do this? To fund pension plans, companies must set aside portions of their profits today to pay for obligations in the future. Determining just how much to set aside is tricky--just as it is tricky for each of us to figure out how much to set aside to fund our individual retirements. Many companies are realizing that they may not have reserved enough funds to pay their future pension obligations. To manage the risk of having chronically 'underfunded pensions,' many companies dangle one-time lump sum payouts in hopes of getting some of pension liabilities off the books.

Difficulties with managing defined benefit pension plans have driven many organizations to phase them out in favor of 'defined contribution' plans. Defined contribution plans, known to many as 401(k) plans, commonly involve the employer kicking a fixed amount of money into a tax-deferred retirement account for each employee on a monthly basis. The employee is then responsible for managing those funds for retirement. The employee loses the certainty of a fixed monthly retirement payment (defined benefit) in exchange for receiving a fixed amount of money today to save/invest (defined contribution).

Today, defined contribution plans far outnumber defined benefit plans. Those defined benefit pension plans still remaining are mostly legacies of the past that, like mine, are in the process of being wound down.

So, should I accept the lump sum buyout now, or wait six years to draw my scheduled monthly pension when I turn 65? Is, as they say, a 'bird in the hand' worth more than 'two in the bush' in this case? We'll discuss the pros and cons of each alternative in an upcoming post.