As the title of this Pension Couch post suggests, I help solve the mystery behind a lump-sum offer for a reader. I decided to code-name that reader Charleston because I have relatives who live in South Carolina. As with all Pension Couch posts, most of this article is made up of my lightly edited email to Charleston. In that email, I analyzed her two options: either take the lump sum or stick with the pension annuity. The wild card that makes this article different from my other lump-sum articles is that her lump-sum offer was from what’s known as a church pension plan (aka church plan).

I’ve never written about a lump-sum offer from a church plan. Actually, I’ve never written about church pension plans full-stop. Moreover, while I discuss them in this article, I don’t go too deep. I’ve made a note to write a post on church plans for the Pension Series in the future, though, because they’re an important topic. In the meantime, all you need to know is church plans don’t have to abide by the US’s Employee Retirement Income Security Act of 1974 (ERISA). For those of you unfamiliar with ERISA, it is the “federal law that sets minimum standards for most … retirement and health plans in private industry to provide protection for individuals in these plans.”

Since church plans in the US don’t have to follow the federal minimum standards, their inner workings are somewhat opaque. This opacity can create some severe pension safety concerns for plan members. Moreover, it also turns out the lax rules governing church plans impact how these plans can calculate lump-sum offers. Therefore, the mystery in this story isn’t a “who’s done it?” but a “how was it done?”

Charleston Did Her Homework

Much to her credit, Charleston understood many of these issues before contacting me. She had determined that her upcoming defined benefit pension from a religiously affiliated hospital system wasn’t 100% secure. She knew this because pension plan members had recently forced the hospital system to settle a lawsuit in US federal court. During the lawsuit, the members alleged that the system’s pension plans failed to meet the ERISA definition of church plans and should abide by ERISA regulations. Per the legal argument, the system had violated ERISA’s minimum standards by chronically underfunding its multiple pension plans (to the tune of ~$800 million), failing to issue annual statements, and not providing proper plan descriptions.

The legal settlement resulted in an agreement by the hospital system to inject large cash deposits into the worst-funded plans over five years. That’s pension plans plural because the hospital system runs a separate church pension plan for each US state it operates in. Crucially, however, since this was a settlement and no court ruling was issued, the hospital system’s pension plans remained church plans. So that was problematic for Charleston.

Charleston’s lump-sum offer was also problematic because it was small — really small. Again, much to her credit, she had run the numbers before she contacted me. In doing so, she determined that she’d need a 15.5% average rate of return for the invested lump sum to recreate her pension’s annuity payments. That seemed unreasonable to her, and I agreed.

As a result, she asked me if she should “take something or gamble it will be there in 9 years?” Of course, I told her I couldn’t tell her what to do because I’m not a licensed professional. Still, I could examine her pension along with the lump-sum offer, so she could better understand her options. Much like the CSI television show, my examination was forensic, as I tried to piece together how everything worked and impacted her.

Just The Facts, Ma’am

Like many of my Pension Couch subjects, it took Charleston and me more than a few instant messages to determine all the facts about her situation. Moreover, I told her about my master pension value calculator from Pension Series Part 13, which she used to make more independent calculations. However, afterward, she was even more confused about how her company came up with the lump-sum offer. As a result, unlike other Pension Couch articles, I’ve chosen to summarize her details below for the sake of brevity. Afterward, I cut and pasted my analysis almost verbatim from my final email to her.

Here are the facts. When Charleston wrote me in October 2021, she was just about to turn 56. But, her pension from her previous employer was not scheduled to start until age 65. If she stuck with the pension annuity, it would pay her $10,557 annually. The pension didn’t come with healthcare, a cost-of-living adjustment (COLA), or any other earned benefits. Like all US pensions, it came with a survivorship option, but she didn’t plan to take it due to her excellent health and her husband’s age (15 years her senior). Charleston also had no intergenerational wealth concerns or heirs.

Charleston’s lump-sum pension buyout offer was $64,000, and it was scheduled to pay out in December 2021 if she took it. That would leave a 9-year gap between taking the lump sum and the original start date of the pension annuity. The lump-sum paperwork showed the offer was calculated using a 6.5% interest rate and the Internal Revenue Service’s (IRS) unisex mortality table.

Speaking of mortality, Charleston believed she would live until at least 90. However, that’s not the life expectancy I used in my calculations. As explained below, I used something similar to the IRS table to mirror what the pension fund used.

The Pension Plan’s Facts

Charleston also gave me a bunch of information about her former employer and her pension fund. But, as already mentioned, the pension plan’s church status meant they were exempt from ERISA requirements to produce helpful information like annual statements. Charleston’s former employer took full advantage of those lax rules, and it took some digging to find the pension plan’s projected funding status and shortfall.

I initially found some press reports from the lawsuit (2017) that stated there was a 34% shortfall. However, Charleston dug up a company financial report from fiscal year 2019. Based on that report, I calculated that the pension fund had a 32% shortfall for all current and future obligations. As a result, I used the 32% shortfall in my calculations, caveated by the fact that I wasn’t entirely sure that I had found all the numbers. Charleston was OK with that.

Learning By Doing

Not to be overly dramatic (although that’s never stopped me before), but determining the funding shortfall played a crucial role in understanding Charleston’s two options. It’s also worth mentioning that many other factors also figured into Charleston’s situation. As you’re about to discover, ERISA rules for lump-sum calculations, different gender life expectancies, inflation, and the pitfalls of modeling retirement scenarios are mentioned in my analysis below.

That’s a long way of saying this stuff is complicated, and no one should feel bad for not understanding it all. That includes Charleston, who may have expressed that she felt like she was asking dumb questions on more than one occasion. Nothing could be further from the truth, though. This was iterative learning for both of us. I was learning about church pensions, and she was learning how to compare the lump-sum to the annuity.

This brings us too…

GM’s Analysis

Charleston,

I’ve attached my version of the pension value master calculator for your case. You should open it and follow along.

If you go to the ‘scenario & assumptions’ tab, you’ll see I entered the details of your situation. The entries include your lump-sum offer’s value, annuity’s annual payment total, current age, age at which pension starts, life expectancy, etc. You’ll also see that I used a 6.5% yearly market return with a 3% inflation (the historical average) assumption to give you a real rate of 3.5% annually. I chose the 6.5% return rate because your former employer used it in the lump-sum calculation.

For this scenario, your retirement life expectancy is 84 (65 + 19). I derived a 19-year retirement life expectancy by averaging the Social Security Administration’s (SSA) life expectancy for 65-year-old males and females together. For convenience, I linked the SSA’s table on the first page of the calculator. Your pension fund used the unisex IRS mortality tables, and while I can find them, I don’t know how to read them. However, they are probably similar to the SSA’s. The critical fact is that there is a 2.5-year difference between male (18.1 years) and female (20.7 years) life expectancy at 65. Females live longer.

Life Expectancy Rules Work Against Women

Right off the bat, let me say that using a 6.5% interest rate and the unisex mortality tables works against you receiving a larger lump-sum offer. The effect of the unisex mortality tables is easier to understand; it shorts you an extra year’s worth of compensation as a woman. So, let’s assume their calculations led them to decide that each year of future compensation in retirement was worth $3,368 in present dollar value terms. Then instead of $3,368 x 19 = $64K, you should’ve gotten an offer akin to $3,368 x 20 = $67.3K.

That said, federal rules require the use of unisex tables unless pension plans apply for an exemption to use separate tables for each gender. I’m not sure what the justification needs to be to get that application approved. Still, nothing you’ve told me about your company or pension fund would lead me to believe that they would have bothered to apply for it. To ensure that unisex tables were used across the board, you could inquire with a male colleague who also received an offer.

Who Needs Interest Rate Rules?

The effect of using a 6.5% interest rate is a little more complicated but also more critical. Essentially, as your paperwork states, the higher the interest rate used, the smaller the lump sum. A lump-sum offer is built around the assumption that the recipient will invest and grow it into a pool of assets that can produce an equivalent amount of money as the pension annuity over the estimated retirement lifespan of the recipient. Thus, a lump sum is a discounted present-day value estimate for the totality of future pension annuity payments.

In your case, the pension fund believes that you can earn a 6.5% return when you invest your lump sum. As a result, they’ve discounted the future value pension by the 19 years of your estimated retirement life span and the 9 years that currently separate you at 56 from your first pension payment at 65. In other words, according to their math, 28 years of compounding at 6.5% annually would grow that $64K lump-sum into a pool of assets that could provide 19 years of withdrawals, similar to your pension annuity.

If your pension was a Single Employer Plan (SEP), administered under ERISA requirements and covered by the Pension Benefit Guarantee Corporation (PBGC), it couldn’t use an arbitrary interest rate like 6.5% for lump-sum calculations. Instead, they’d have to use the corporate bond “segment rates” published each month by the IRS. Those segment rates are currently much lower than 6.5%, which means if your pension fund did use those rates, then your pension lump sum would be a lot more. However, since your plan is a church plan, they do not have to use the IRS segment rates. I believe they must still abide by the ERISA requirements to offer a “fair deal,” but I don’t know how a fair deal is determined.

A Segue Into Assumed Rates of Return

As a potentially interesting aside, the 6.5% interest rate may be the actuarially assumed rate of return rate the administrators use when calculating future returns for the pension fund. In the company’s financial report you sent, the actuarial assumption used for “return on plan assets” in 2019 was 7.50%. Several pension funds have modified their assumed return rate downwards in the last few years because 7.5% proved way too optimistic. Your church plan may have done the same, making the 2021 assumed rate of return 6.5%. In my opinion, that’s the only justification for using 6.5% in your lump-sum calculation.

Among other things, that assumed return rate is used to determine the pension plan’s funding ratio. Like a lump sum, a higher projected return rate means a smaller projected pension funding gap and vice versa. Although, as I explain below, 6.5% is an overly favorable interest rate to use in lump-sum calculations, it is not an unreasonable rate of return for a pension plan. Many other pension plans that I’ve studied use it, which is far more realistic than 7.5%.

Reverse Engineering The Lump-Sum Offer

OK, let’s move on to calculations. Knowing the interest rate and the life expectancy for your lump sum calculation makes it easy to determine how the pension fund calculated your lump sum. We can essentially reverse engineer their calculations by first determining the size of a $64K investment compounding for 9 years (from age 56 to your pension annuity start at 65) at 6.5%.

Look at the bottom left-hand block of yellow calculations on the Grumpus Maximus tab in the Excel spreadsheet with “First year difference between SWR and annuity amounts” written in bold beneath it. You’ll see all the inputs from the first page. Ignore the safe withdrawal rate line, as it doesn’t apply here. Concentrate of the line after it, which says “Invested Lump Sum Value at Annuity Start” and has a value of $112,804.50. That is the projected value of your lump-sum offer after it has compounded the 9 years from 56 to 65, which is when your annuity would start if you did not take the lump sum. I determined it using a simple compounding interest formula.

Now, look at the bottom line in that block of calculations, the one that says “Spend to zero scenario (in years).” You’ll see a value of 18.83. That’s 18.83 years. That’s how long it would take to spend a nest egg of $112,804.50 (that’s compounding 6.5% annually) down to zero by withdrawing $10,557 each year starting at 65.

18.83 is close to 19 years, which is your life expectancy at 65 according to the mixed-gender life expectancy from the SSA. I determined 18.83 years by using the NPER function in Excel, which calculates the number of payment periods an annuity will pay out before it runs out of money. If you click on the cell with 18.83 on it, you’ll see the formula I used along with the cells that provided the inputs. The NPER calculation included a 6.5% interest rate (cell C22), your annual $10,557 pension benefit (cell C17), which would be the withdrawals, and the initial invested amount of $112,804.50 (cell C22, but a negative value because you’re investing it). I also put the final sum at zero (the 0 next to the -C22 in the formula) and made the withdrawals at the end of each year (the last 0 in the formula).

I found a great website that visually displays all this information for you, and it’s located here. Interestingly, if you switch your annual $10,557 payments to the beginning of every year instead of the end, payments would only last 16.77 years. You can make that switch on the webpage by clicking on “settings” and hitting the radial button that says “beginning.”

Modeling Volatility 

The 6.5% interest rate is problematic for several reasons. First, these are straight compounding scenarios with no volatility from one year to the next on the rate of return from your investments. If you could buy a bunch of treasury bonds with a 6.5% interest rate, then you wouldn’t need to consider volatility. However, you’re not going to get that rate from bonds in the current interest rate environment. That means you’d have to invest in stocks to gain the compounding effect you need to make 6.5% achievable. As you probably know, stocks are subject to ups and downs (volatility) and risk (of losing value instead of gaining it).

I ran the entire ‘invest the $64K lump-sum at 56 and make withdrawals starting at 65’ scenario in Flexible Retirement Planner (FRP – which uses Monte Carlo scenario modeling). I used a 6.5% average return for that scenario and added the potential of volatility swings of 10 percentage points (meaning returns could go as high as 16.5% or low as -3.5% to achieve that 6.5% average). Accordingly, the likelihood of your money lasting 19 years while withdrawing $10,557 annually falls to 31%.

Moreover, suppose I model you investing that $64K entirely in an S&P 500 index fund at age 56 and use the historical return rates (12.3%) and volatility (+/-20.2% points) for the S&P500 built into FRP. In that case, it still only gives you a 74% chance of success of making it to 19 years while withdrawing $10,557 annually. Since you initially found that you needed a 15.5% rate of return for a 25-year retirement, I plugged in a 15.5% average rate of return with the S&P’s volatility (+/-20.2%) into the FRP scenario. It produced a 90% chance of success at 19 years, which means your initial calculation was pretty accurate.

Modeling Inflation’s Volatility

6.5% is an unrealistic interest rate to use in calculating your lump-sum, in my opinion, due to the reality of volatility. Its use artificially deflated your lump-sum offer. Also, the 6.5% return ignores inflation. Now, your annuity is not inflation-protected, so technically, your lump-sum offer doesn’t need to consider it either. In fact, one could argue that stocks are an inflation hedge, and by taking the lump sum and investing it in an S&P500 index fund, you’re insuring against inflation. I think there is some merit to that argument, and that is an edge that taking the lump sum over the annuity provides.

However, inflation (as we are currently seeing in late 2021) is also volatile. Incorporating it into the above FRP scenarios significantly decreases the chances of your money lasting 19 years. For instance, that last scenario I ran with your 15.5% average return rate drops from a 90% to a 75% chance of success when I add a 3% average inflation rate with a volatility of +/- 2 percentage points. The likelihood of success from investing in an S&P 500 index fund drops from 74% to 49%. So, again, a 6.5% average rate of return is also unrealistic when considering rates of return on a real basis (i.e., including inflation) versus a nominal basis (i.e., ignoring inflation).

Annuity Analysis

OK, that’s the counter-factual for the lump-sum examined. Let’s now look at the counter-factual argument for and against the annuity. Look at the upper-left-hand part of the Grumpus Maximus tab. You’ll see a yellow box with ‘*TDV of Pension’ written below it and a value of $149,981.77. This is the retirement year-one sum (i.e., at age 65) of all future pension payments your pension plan would pay you if you took the annuity and lived to 84. It’s adjusted downward for that 3% inflation rate over your 19-year retirement lifetime.

However, that annuity starts 9 years in the future, so we need to further reduce that number to today’s present value dollars using the same 3% inflation rate. In doing so, I came up with $114,948.54. I determined that amount through Buyupside’s inflation calculator linked here: https://www.buyupside.com/calculators/inflationjan08.htm

What does this number tell you? It tells you that if you took the annuity at age 65 and lived to age 84, the total sum of all pension plan payments would equal $114,948.54 in today’s dollars. By living to 84 and assuming a 3% inflation rate (the historical average), you’d earn $50,948 (114,948 – 64,000 = 50,948) more than your lump-sum offer in today’s dollars.

Now, $114,948.54 is only adjusted for inflation, and it isn’t discounted for opportunity cost (which we calculated above) or risk. However, I like this number because it provides a risk-free ideal value for your pension’s annuity payments assuming the inflation rate and lifespan assumptions are accurate. Meaning you don’t have to do anything other than fog a mirror (i.e., live) to 84 to receive this money. Living beyond 84 adds gravy to the annuity argument since, as we just saw, your pension plan calculated the lump sum assuming you’d die around 84 years old.

The Annuity’s Risk

Regarding risk, we can further adjust the $114,948.54 for the fact that your company’s pension is underfunded. That’s what the second part of the Grumpus Maximus tab (ALDV for Lump Sum offer) on the spreadsheet calculates. But, for your scenario, it doesn’t work. So, I calculated it by hand.

I found a 2017 news article that stated the pension was 34% underfunded in 2015. However, the 2019 company financial report you sent me showed the pension plan’s funding gap had shrunk to roughly 32%. Therefore, I’ll use 68% as the funding ratio in my calculations below.

A crude way of incorporating that risk into your annuity scenario would be to shave 32% off the projected TDV of your pension in today’s dollars (i.e., that $114,948 figure). In doing that, I came up with $78,164. That’s a lot less than $114,948 but still $14,164 more than your lump-sum offer. So, by accounting for inflation and the risk of your pension not paying out in full, we’ve reduced the gap between your lump-sum offer and your potential total pension payments by quite a bit. But, taking the annuity still puts you ahead.

Other Pros For The Annuity

Furthermore, any amount of time you live over the age of 84 puts the annuity further ahead of the lump sum. Of course, inflation would still be eating away at the total value of that annuity in real terms. But, unlike the lump-sum investment scenario we ran earlier, you wouldn’t run out of money. That said, all the assumptions (life span, inflation rate, and inflation) have to play out accurately for the annuity math to work.

All the other tabs in the master pension value calculator, with their different ways of calculating the value of your pension, generally show that your annuity is more valuable than the lump-sum offer. I’m not sure why I told you to look at the “4% Rule vs Pension Buyout” tab. That tab only makes sense if you want to pass on your pension wealth in its invested lump-sum form to future generations. Your circumstances with a spouse 15 years your senior and no kids further decreases the argument for taking a lump-sum offer and nullifies the need to look at that tab. I say that because there is a minimal chance that your pension will need to support a widower after you die. You also do not need to pass on wealth intergenerationally.

I’m Beginning To Dislike Church Pension Plans 

The fact that your pension plan still considers itself a church plan is a cause for concern. There’s a lot of legal precedence regarding lack of recourse for plan members when church plans fail. That said, the results of the court settlement assuage those fears somewhat. Based on the court settlement’s outcome, your pension plan isn’t in a death spiral. The probability that it pays out as required appears much higher than the probability that you could earn a 15.5% average return on your lump-sum investment, or even a 6.5% return. The amount of risk that you’d incur to secure that 15.5% average return seems far higher to me than the risk of your pension plan failing or inflation eating the value away to nothing.

At this point, Charleston asked a follow-up question since she found some language in the 2019 audit report that the pension fund was going to publish annual reports in line with the Federal Accounting Standards Board’s (FASB) recommendations.

The fact that the pension fund cited FASB recommendations for reporting is a good sign. However, in and of itself, it doesn’t mean that the plan will publish an annual statement … or one that’s of any use at least. Despite its official-sounding name, the Federal Accounting Standards Board’s (FASB) recommendations are just that, recommendations. Think of them as best practices. Even though most do, there is no requirement for pension funds to follow their rules.

In reality, church plans don’t even have to follow federal standards. Check out this link to the pro-pension organization pensionrights.org which explains church plans’ exemptions under federal law. That said, my hope for you is that the lawsuit convinced your pension plan’s administrators that it should follow the annual reporting formats recommended by FASB.

My Final Thoughts For Charleston 

That’s it for my analysis. Your instinct that the lump-sum seems low is correct, and the math points towards the annuity as the more efficient play. However, given your company’s history of less than upstanding support for its pension plan, I think you are right to question everything. Let me know if there’s anything else I can do to help. I’d like to use our exchange as a Pension Couch post if you’re willing. A lot of people could learn from your situation. I’d give you the chance to review it before posting to ensure everything is accurate and anonymized to your satisfaction.

 

In need of pension analysis? Email your questions to grumpusmaximus@grumpusmaximus.com.

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