BOSTON (MarketWatch)—Imagine for a moment that you’re one of some 90,000 retired white-collar workers at Ford Motor Co. and you learn—somewhat unexpectedly—that the company plans to offer you a voluntary lump-sum defined benefit payment.
Well, you don’t have to imagine this any longer. It’s really happening. In what’s been described as the first offer of its kind, retired Ford (US:F) workers will soon have to decide whether to take a lump-sum distribution from their defined benefit plan, or take (or continue taking in some cases) their pension in monthly installments.
It’s will be tough choice and, even though it’s a routine question for many workers who retire from companies that have defined benefit pension plans, there are no easy answers.
In fact, the answer will depend on many factors that are unique to the
person asking the question. “There are multiple factors to consider in a situation like this and there is no one-size fits all solution,” said Richard Stebbins, an associate professor at the College for Financial Planning.
Others agree. “Every individual will face a different set of circumstances,” said Matt Herrmann, the leader of Towers Watson’s retirement risk management group.
For instance, Christian Weller, an associate professor at the University of Massachusetts-Boston and a co-editor-in-chief at the Labor and Employment Relations Association, said, “evaluating lump-sum payments instead of annuities depends on interest rates, life expectancy, and personal decisions.”
Here’s a closer look at those and other factors that retired Ford workers should be consider when deciding to take the lump sum or not.
How’s your health?
If you’re in
poor health, consider taking the lump sum (especially if you didn’t take or don’t plan to take a joint-and-survivor annuity). “A lump sum will allow (you) the chance to enjoy a benefit today and possibly leave something behind to help out (your) family, favorite charity, or any other entity (you) feel deserving,” said Stebbins.
If you have no immediate health concerns, consider the economics of the offer.
Net present value and discount rates
One way to look the economics of the offer is to compare the dollar amount of the lump sum against the present value of the expected pension payments, according to Stebbins. For example, let’s say your lump sum offer from Ford is $250,000 and your monthly benefit is $2,000. And, let’s say you’re 70 years old, single, and you’re in good health but your family doesn’t have a history of living much past 85.
Assuming an interest rate of 3% and a life expectancy of 15 years,
you’ll find that the present value of your monthly pension is $300,000, some $50,000 more than what Ford is offering. In other words, using those assumptions, your monthly pension is a better economic deal than the lump sum offer. (By the way, you can find a present value of an annuity calculator by doing an online search for that term.)
Weller explains it this way: “Ford will assume a long-term interest rate when calculating the lump sum, but the worker may have much less time to invest the money. Long-term interest rates are greater than short-term interest rates. And, higher interest rate will reduce the lump-sum payment since compounded interest earnings will contribute a larger share of future income than lower interest rates. So, the individual investor may come out worse with a lump sum than an annuity simply because their life expectancy is shorter.”
The life expectancy riskNow truth be told, this is one reason why Ford is making this offer. Ford says it’s de-
risking its $39.4 billion pension plan. But in reality, it’s merely transferring its risk to the retiree.
Instead of Ford having to meet its obligations, the retiree will assume the obligation of making their money last over the course of their lifetime. And the big problem with that transfer of risk is this: Ford gets to use the law of large numbers when managing its pension plan. It’s betting on the fact that some retirees will die before life expectancy and others after.
The retiree, by contrast, will have to use the law of one number when managing his or her lump sum. And if they underestimate their life expectancy, they’ll come out on the losing side of the bet.
So another factor to weigh is whether you want to assume risk of not outliving your assets or leave that risk with Ford. The answer to that, of course, depends on your life expectancy and your ability to
Can you manage money better than a pension plan?
At the core, Ford retirees will essentially be asked to evaluate the trade-offs between having greater control over their investments and the security of a guaranteed lifetime income stream, according to Herrmann.
“The annuity stream is set but we also need to consider possible growth on the lump sum if it is invested,” said Stebbins. “What type of return can the employee expect on his (or her) lump sum investment?”
This, of course, depends on the investment or mix of investments. But one thing seems certain. Retirees who take the lump sum are unlikely to convert their entire distribution into an annuity for many (and perhaps many would say, good) reasons. And, that could be problem as well, according to Weller.
“Let’s say they want to use the money for retirement income,” said Weller. “They now need to plan for the maximum life expectancy to
avoid running out of money. Maximum life expectancy is around 105 years. The pension and any insurance plan, though, would have to plan only for the average life expectancy for the average insured participant. The average life expectancy at age 65 right now is around 83 years, a lot less than the maximum life expectancy. A shorter life expectancy, though, means that the household has more income. So, self-managing the money may be worse than buying an annuity in terms of income.”
Perhaps, but annuities aren’t paying all that much these days, less than inflation in fact. For instance, one firm is currently offering a 2.45% guaranteed rate for a 10-year annuity based on a 60-year-old with $200,000. There are other problems with annuities that must be considered, as well. “The money cannot be passed on to the next generation,” said Weller. “They distribute money from people with short life expectancies to those with long life expectancies. So, an annuity is not always a good option.”
nAnnuities in the absence of other investments might not be a good option. But Ford retirees who take the lump-sum distribution will have to manage their money in ways that address many of the risks of retirement, including longevity, inflation, and sequence of return. And that might require a different sort of asset or “product” allocation.
For instance, Ford had as of the end of 2010 its pension assets allocated across many different types of investments (22% in U.S. equities, 20% in international equities, 46% in fixed income, 7% in hedge funds, 4% in private equity and the rest in real estate and cash) and it was assuming a 7.5% rate of return.
But Ford retirees who take the lump-sum distribution shouldn’t invest that way or assume that sort of return. Instead, they might consider dividing their assets not just among risky assets (stocks and bonds), but among annuities
with guarantees and income annuities as well.
Options are better than no options
No matter whether the Ford retiree decides to take the lump sum or not, one thing is certain: Retirees who have the option of taking a lump sum or a monthly pension are better off than those who have no option. “We believe that the option to select a lump sum provides plan participants with greater flexibility to plan for retirement income needs, including more control over the timing of retirement income, as well as more control over how retirement income assets are invested,” said Herrmann.
Robert Powell is a featured writer on the MarketWatch Retirement blog, a Research Fellow at the California Institute of Finance, and a Featured Contributor here on the “Advisor Blo