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As traditional pension plans continue to decline, many employers have frozen their plans; some are even offering buyouts to completely remove future pension payments from their financial obligations. If you're offered a buyout for a pension you've earned from an employer, deciding whether to keep the pension or take the buyout is a difficult decision.
Fortunately, there are just three key factors that drive the decision for you. Two of them are make or break, and the other is more of a judgement call. If you take just a few minutes to think through them, you can make the decision much, much easier.
The make or break factors
The first make or break factor is the answer to this question: Do you think the pension plan will still be around when you're eligible to collect?
Even if you don't think the pension plan itself will be there, keep in mind that it may be insured by the Pension Benefit Guaranty Corp. The PBGC will backstop a covered pension up to certain limits, depending on your age and when an insured pension goes belly up. PBGC coverage limits are available on this page. Not all pensions are covered by PBGC, however -- as Detroit employees and retirees found out when that city went through its bankruptcy proceedings.
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If you're certain that either the pension itself or PBGC coverage will be there and be adequate to cover what you've been promised, then this becomes a non-issue. If, on the other hand, you're worried that the pension (or sufficient PBGC coverage) won't be there for you, then taking the buyout becomes an easier choice.
With that out of the way, the second make or break factor is the answer to this question: Do you trust yourself to prudently manage the lump sum if you take it?
If you're legitimately afraid that you'd cash in the pension early, pay the tax and penalty, and blow the rest of the cash, then by all means keep it in the hands of the pension plan. Theoretically, having the money in your hands could give you the opportunity to invest it so it grows to a better result than the plan itself could guarantee. Still, if you can't trust yourself with the money, then don't take possession of it.
If, on the other hand, you're just concerned that you're not a strong investor -- take heart. Here's a link to a free and straightforward investing strategy that can teach you the basics in as little as an afternoon. The downside to investing your own money is that you're responsible for managing the risk/reward trade-offs inherent in investing. The upside, however, is the likelihood of a substantially higher potential return than a prudent pension manager could guarantee.
The judgement call
The last factor is more of a judgement call than the other two, and it can be found in the answer to the question: Do you think you can wind up better off with the lump sum?
When it comes to answering this, here are a few points to consider:
- How long will you live? Pension buyouts are based on large group actuarial projections, not your individual circumstances. The longer your expected lifespan, the better off you are keeping the money in the pension. If you're not expected to live long, taking the lump sum can help you and your heirs. On the other hand, if you expect to give Methuselah a run for the longevity record book, then making the pension plan manage that longevity risk may make more sense.
- How much will your investments return?Your pension plan's buyout is based on an assumed rate of return based on prevailing interest rates. In today's low interest rate environment, it is likely that a well-managed, stock-focused portfolio with a long-term time horizon can beat that buyout rate. If you're already nearing retirement, your allocation will likely shift away from stocks at least somewhat, making that hurdle rate tougher to beat.
- How far away are you from retiring? The closer you are to retiring, the less time you'll have for stocks to work their long term magic for that higher potential return. Additionally, if you've been accruing benefits for an entire career, your promised monthly payment may well be sufficient to cover your retirement costs. So even if you could beat the pension's promises by investing the lump sum on your own, you may not need to.
Take control of your financial future
If you're already an experienced independent investor, you'll likely find that the option of a pension buyout is a great opportunity to get your hands on more of your own money. If it's your first exposure to investing on your own, however, the task of managing your own money may seem like a daunting and imposing one.
In reality, just a few simple principles and a straightforward framework will let you do an incredible job. So look at the buyout offer as your chance to take control of your financial future, and get started now.
The article Should You Take the Pension Buyout? originally appeared on Fool.com.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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