One way to evaluate a pension buyout involves determining what your future pension payments are worth today and then comparing that value to the buyout offer.
A pension plan—typically offered or “sponsored” by an employer—provides a stream of payments over the course of a person’s lifetime. Whether these payments are inflation adjusted and whether payments continue to be made to a surviving spouse are both critical factors that vary from plan-to-plan.
The term pension refers to the “classic” type of defined benefit pension plan and should not be confused with defined contribution plans such as 401k plans. The distinction is important because defined benefit pensions provide lifetime income payments and retirement savings plans like the 401k do not.
Although defined benefit pension plans are now a rarity in the private sector, there are many recent examples of buyouts among corporations that have desired to remove these very burdensome liabilities from their balance sheets. U.S. auto manufacturers such as General Motors have provided recent examples.
A pension buyout offer—sometimes referred to as an “early retirement” offer—is often a lump sum cash offer from the plan sponsor (employer) to the plan participant (employee). The cash offer is intended to represent some portion of the value of the future pension payments.
The value of a pension buyout to participant or employee is presumably (and this is debatable) the up-front cash. From the perspective of the pension plan sponsor, much of the value of a pension buyout resides the ability to get the obligation or “liability” off of their books.
A pension buyout offer is presumably some portion of the actual, “real” value of the pension payments.
Again, the key question for the person who would be receiving the pension payments is what the actuarial fair value (the “real” value) of those pension payments, and how the pension buyout offer compares to this actuarial fair value.
Some of the simpler factors involved in the computation of the actuarial value of a pension buyout include: age; gender; years until retirement or when pension payments would begin; the amount of monthly or annual pension payments, and; current interest rates.
Consider, for example, a case study that surfaces when searching for pension buyout on Google. One of the top search results is a discussion thread on the Bogleheads website titled “Pension Buyout Offer – What to do.”
The scenario involves a 41 year old single male who received a pension buyout offer from a previous employer.
The offer consists of 3 alternatives:
- $490 per month when he turns 65
- $62 per month starting now
- $17,000 right now to “walk away” and wipe the slate clean for his previous employer
Ignoring, for a moment, all of the behavioral aspects of the decision, how would one make a rational comparison of these 3 alternatives?
Let's take a look at the actuarial present value of each of the 3 options:
The purely rational decision based on the actuarial present value would be $490 per month starting at age 65. This is an actuarial present value so it takes into account mortality factors or the probability that this person will live until age 65 and beyond.
However, what is not taken into account is credit risk or the very real possibility that the employer will file for bankruptcy sometime during 24 years before this person turns 65. In addition, there is the potentially enormous impact of inflation (assuming no inflation adjustment) on the real value of the payments.
The critical role of interest rates is also something that surfaces very clearly in this example.
Some basic sensitivity analysis reveals what this decision would look like if the 10 year Treasury (our discount rate) is 4 percent rather than the 2.3 percent rate we used above:
One item to note is that the $17,000 lump sum payment in the 4 percent interest rate example above would most likely not remain $17,000. The lump sum offer would almost certainly be affected by the higher interest rate—higher rates result in lower pension liabilities and therefore a lower value on any lump sum offer.