Based on the title of this post, can you guess which article on the Golden Albatross blog has the most views? If you said The Pension Series (Part 17): Buying Years – A Case Study, then have a beer on me. I promise I’ll pay you back when I get my next US $20 royalty check from my publisher! In any case, the contest isn’t even close. Part 17 has triple the number of views than the second most-viewed post, The Pension Series (Part 3): What Is Your Pension Worth?. It’s probably as close to viral as one of my pension-related posts will ever get. Although, it did this over two years instead of two weeks. I guess that means a lot of readers have access to a pension buyback.

As I describe in Part 17, a pension buyback (aka buying back years) is a process through which pensionable workers can transfer the number of years they worked in a former pension plan into their current pension plan through a cash purchase. This allows the pensionable employee to increase tenure (in the eyes of their current pension system) when the value from their previous pension doesn’t transfer over. Therefore, it makes a pending pension annuity from the current pension plan more valuable. As a result, buying back years isn’t typically cheap. Pensionable employees with this option need to determine if the purchase is worth it.

The option to buy back years isn’t offered universally by pension plans. If you want to know more about the basics of a pension buyback, and how to calculate if it’s worth it, I encourage you to read Pension Series Part 17 if you haven’t already. Doing so will boost your understanding for the remainder of this article … and increase those view numbers even further!

Persistence Pays Off

Considering how popular pension buybacks are amongst my readers, it shouldn’t surprise you that the article generated several comments over the years. It’s also spawned several emails. One recent email caught my attention because it came from a reader whose comment I failed to answer when he originally posted it on the blog. Based on the commenter’s call sign, ILoveBaconCheeseBurgers, let’s call him Cheese. Not Rich, not George, just Cheese.

To my embarrassment, Cheese patiently waited two years for an answer to his comment about his pension buyback plan. After nothing but silence, he commented again and then emailed me. It’s rare for people to follow up on their comments on my blog, and I felt bad for not responding to the initial comment. As a result, I decided to give Cheese’s email the royal treatment. One might even say I gave him the “Royale with Cheese.”

Sometimes Procrastination Pays Off Too

In a way, it was good that I didn’t respond to Cheese’s original comment. I say that because the situation changed for him and his spouse over the intervening two years. A global pandemic can do that to a couple with two pending pensions — especially when one is a public-school teacher.

Cheese originally sought input on his 8-year pension buyback opportunity. However, in his recent email, Cheese asked me to double-check his reasoning as he compared his pension buyback option to his wife’s. He wanted me to examine whether or not his wife’s pension buyback was as good as, if not better than his. The request was intriguing because buying back nine years in Mrs. Cheese’s pension would allow her to retire five years earlier than she would otherwise be able to do. This was something Cheese’s pension buyback did not qualify him for.

Since Cheese’s request now had more meat, I decided to sink my teeth into his bacon cheeseburger. And, so, began an epic exchange of emails. Don’t be put off. I’m not going to force you to read the entire conversation. I decided to significantly truncate the exchange by simply summarizing key points. In the end, I hope this provides a good overview of the process by which I analyzed the money side of the issue along with the non-money side.

Buyback Scenario 1

Cheese originally posted the following on my blog in August 2019:

I am 49 years old and 14 years into a pension that pays 52% at 20 years on the job for those 52 years or older. It maxes out at 76% at 32 years. The pension plan is 100% funded. I served 9 years in another state, but they will only recognize 8-years & 1 month. My figure for a 52%, 20-year pension is $39,715 at age 55. An 8-year buyback would cost approximately $175,000. It would qualify me for a 68%, 28-year pension at 55 that pays $51,935. By my math, the buyback pays for itself in roughly 13 to 14 years. This pension buyback is possible through the magic of my 457 fund and a previous small pension, combined with compounding interest.

As great as Cheese’s plan looked, it did not survive first contact with the enemy. First off, the local government organization that Cheese works for signed a new contract with its labor force before he could execute the purchase. That meant Cheese got a significant raise that impacted his pension formula for the better. But it also meant the purchase price went up. If Cheese had not executed the buyback, the new baseline 20 YOS pension would have increased to $45,100 annually starting at age 55. However, the 8-year buyback now qualified him for $58,977 annually, starting at age 55 based on 28 YOS. The new cost for the buyback was ~ $180K. These are the figures I used in my calculations below.

Situation Normal, All F’d Up

Cheese started the buyback in August 2019 with a ~$67K payment from a previous pension account. That said, he couldn’t complete the purchase until April 2020 with a $113K payment from his 457. This was due to a bureaucratic SNAFU with the pension fund’s administrators. For those unfamiliar with a 457, it’s a deferred compensation account that allows employees to divert a percentage of their wages into it. By doing so, they also defer any income taxes on those wages until they withdraw the money from the 457 and realize it as income. However, in this case, Cheese didn’t have to realize the withdrawal as income or pay income tax since contributions into a defined benefit pension (DBP) fund are also tax-deferred.

That said, if you’re going to fund a buyback from a 457, then consider the SNAFUs in Cheese’s final payment as a warning. You need to plan ahead, engage the people/organizations involved early, and expect delays. As he relayed to me, “I kept calling and pretty much was on a first name basis with the people at the pension fund.”

Buyback Scenario 2

This is how Cheese described his wife’s deal in September 2021:

I calculated my benefit, presuming my soon-to-be age 54 wife’s pension buyback was nothing to consider because her pension was much smaller. Recently I realized hers might make a stronger case than mine.  Here are the details…

She taught for 9 years in another state. She has taught for 21 years in this state. Her current pension formula is years of service (YOS) x average of highest 5 years of compensation x .011 (multiplier). To qualify, an employee’s age and service must equal 85. An example of the rule of 85 is 30 YOS at age 55 would qualify an employee for retirement. The following also qualify for retirement: 10 YOS at age 65 or 15 YOS at 60. 

As Cheese explained it to me, his wife had four options regarding retirement and her pension:

1. 1. Quit next year (age 55), wait 10 years, and collect the pension at age 65
   2. Work until age 59 and earn 26 years of service, which equals 85
   3. Quit next year (21 years of service) and wait till age 60 with over 15 years of service credit
   4. Buy 9 years of service (YOS), add it to her current 21 years, and qualify November 2022 under the rule of 85 (age 55 with 30 years of service)

As he relayed to me, with options 1 and 3, the pension value stops accumulating interest during the waiting period. Therefore, both were subject to inflation. Out of the two, option 3 was the better deal due to the shorter waiting period. Furthermore, option 2 wasn’t viable because Mrs. Cheese was “truly done” with the high-stress teaching environment. Apparently, she loved the kids but disliked the bureaucracy that accompanied teaching in a post-COVID pandemic world. As a result, he and Mrs. Cheese were already leaning towards option 4, meaning I just needed to compare option 4 to option 3’s baseline and determine what the buyback improved. Once done, I could then compare Mrs. Cheese’s buyback to Cheese’s buyback scenario.

Cheese made this easy for me since he sent all the information I needed for pension formula calculations. Option 3’s formula looked like this:

$75,000 (avg. salary) x 21 (YOS) x .011 (multiplier) = $17,325 at age 60

In contrast, option 4 cost $150,000 to buy back 9 years. Cheese and his wife would pay for it by withdrawing the sum from a 403b. Once done, the pension formula would look like this:

$75,000 (avg. salary) x 30 (YOS) x .011 (multiplier) = $24,750 at age 55

That is $7,425 more per year than option 3’s annual amount. However, that doesn’t include the five extra years of payments option 4 provides between age 55 and 59, which option 3 does not. So, in reality, the increase in Mrs. Cheese’s average annual pension payment under option 4 is even more considerable. I calculated it below.

Cheese’s Thinking About Option 4’s Payback

As Cheese saw it, the payback for option 2 begins immediately. He’d count the 5 extra years of payments between age 55 and 59 as part of the payback because those are years Mrs. Cheese otherwise would not be receiving any pension at all under option 3. That’s approximately $24,750 x 5 years = $123,750. His calculations then showed that the annual $7,425 difference in pension payments between options 4 and 3 from age 60 to 63 (4 x $7425 = $29,700) would make up the rest of the buyback cost. That’s approximately $153,450 in total additional pension payments by age 63 under option 4 compared to option 3. In simple terms, the buyback would pay for itself in 9 years.

Need To Know

Cheese’s rundown of the two buyback options showed he had a good grasp on a lot of the details for these scenarios. I considered this a good sign because, ultimately, he and his wife were making the decision. That said, I needed a few more details for my analysis of their options.

For instance, I needed to know if either pension included a Cost of Living Adjustment (COLA) because it would impact how I judged the rate of return for the buybacks (as explained below). It turned out that Mrs. Cheese’s pension has a small but intermittent COLA. Each time it’s enacted, it must be approved by the state legislature, which isn’t every year. Cheese informed me that the COLA doesn’t come close to mitigating inflation. He also told me that his pension has a COLA indexed to the first 3% of inflation. In other words, if inflation was only 2%, then the COLA was 2%. But if inflation was 6%, the COLA would max out at only 3%.

Another thing I needed to know was whether or not the money used for the buybacks had to be repaid into the retirement accounts. This would have set up an opportunity cost scenario like I analyzed in Pension Series Part 17. However, neither sum needed to be repaid.

I also inquired about other benefits like healthcare, but neither pension had it attached as part of the defined benefit package.

Want To Know

While “need to know” is good, I also wanted to know if Cheese and his wife had thought through the ramifications of a buyback. We can call that me doing my due diligence because I’d hate for any of my readers to make a big-money mistake. Fortunately, it turns out that due diligence is one of the reasons that Cheese wrote me. He wanted a second set of eyes looking over his plan and judging it. Even though I don’t own a black robe or a gavel, I told him, I could do that. As a result, I hit him with some more questions.

One thing I wanted to know was if Cheese and his wife could afford the buyback. I specifically asked him if the significant expenditure for his wife’s buyback would sink their retirement budget. He assured me that he and his wife had the money to spare in various retirement accounts. The expense wouldn’t significantly disrupt their retirement budget. Yet again, this shows the importance of actually having a retirement budget when planning for retirement! It’s something I’ve written about quite a bit on this blog and in my book.

I also wanted to know about the safety of Cheese’s wife’s pension. Unfortunately, that was a bit of an unknown for Cheese and his wife. So, I hooked them up with a link to Boston College’s Center for Retirement Research, which runs a public pension plan database (PPD). Among many things the PPD does is collect the annual pension plan reports from 210 of the largest state and local government public pension plans. Mrs. Cheese’s plan was in the database, and it turned out it was over 100% funded. Cheese even found his pension in the database, which is 98% funded. So, the two plans were nearly equal regarding pension safety.

Thirdly, I wanted to make sure that Cheese and his wife were not being misled. In other words, I wanted him to double-check that his wife’s buyback, and the increase to 30 YOS on paper, did indeed allow her to retire at 55. Cheese assured me that he had it all in writing from the pension plan. That was good to hear and good enough for me to continue on to my calculations.

Finally, I wanted to know if the Cheeses had any heirs and estate planning considerations. If they did, it would strengthen the argument to invest the buyback money rather than purchase years. However, they don’t have any heirs. Furthermore, they hadn’t identified any charity possibilities yet. So, I dismissed the intergenerational wealth and legacy issues from my consideration.

With that, let’s get to the calculations!

Buyback Scenario #1 Analysis

Since Cheese determined the length of time for the buybacks to pay for themselves, I focused on the efficiency of each buyback. I also modeled the alternative use of the buyback money using my go-to retirement/investment calculator, Flexible Retirement Planner. During modeling, I used the Social Security Administration’s (SSA’s) average length of life for a 55-year-old male, 25 years. That means I modeled Cheese living until 80.

I also compared the annual return rate for Cheese and his wife’s buybacks to my 6% real return rate (i.e., post-inflation) for investments. This is what I used in my own retirement planning. I admit, 6% is conservative. However, it’s based on my research into the DALBAR report and some criticisms against it. In other words, 6% is my reasonable compromise once inflation is considered. None of my calculations included tax costs.

Here’s what I reported to Cheese about his pension buyback opportunity:

Your buyback increased your annual pension payment by $13,877, which is a ~30% increase in annual pension payments. A $13,877 yearly return from $180K (the cost of the buyback) represents a 7.7% yearly return on your “investment.” This means your buyback would essentially equate to an immediate annuity purchase whose yearly rate of return was 7.7% before inflation.

Since your pension has up to a 3% COLA, that means inflation won’t be an issue in most years. I based that assessment on the US’s historical inflation average (~3% annually) and the US Federal Reserve Bank’s stated goal of 2% inflation. Even if you average a 1% inflation rate over retirement, that gives your buyback an annual 6.7% real rate of return. That’s hard to beat if you were to invest the money yourself. To achieve it, your risk profile would have to move higher. You certainly wouldn’t have the same low risk profile that your pension plan provides at 98% funded, which is essentially riskless for you.

Speaking of investing the money yourself, I also examined the “what if” opportunity cost alternative which assumed you invested the $180K to generate annual $13,877 payments on your own, rather than buying back the years in April 2020. That investment modeling showed only a 72% chance that withdrawing $13,877 annually from a $180K investment would last until age 80 in a standard volatility scenario. That’s based on FRP’s rather high average for S&P500 returns (12.3%) and volatility (20.2%) with a 3% inflation rate and a +/- 2% deviation range. My calculations also include the 5 years between your pension buyback and your retirement point, where the invested money would have accumulated returns before tapping it for withdrawals.

See my screenshot of the calculation below:

Thus, assuming you live to 80, buying back those years in 2020 gave you the ability to bring in $13,877 more per year, but with a lot less risk than investing it on your own in an S&P 500 index fund.

Buyback Scenario #2 Analysis

Mrs. Cheese’s buyback scenario was a little more complicated than her husband’s. As discussed above, I used pension option 3 (retire with an annual pension of $17,325 at age 60) as the baseline. I then calculated the average rate of return for option 4 (i.e., the $150K buyback that unlocked an annual pension of $24,750 at age 55) using Cheese’s payoff math. In other words, the calculations had to include 5 years of $24,750 in net returns since those were free years that option 3 did not provide. The calculations also included 24 years of $7,425 increased payments over the baseline pension in option 3.

If you’re doing the life expectancy math, I bumped Mrs. Cheese’s life expectancy to 84 to match the SSA’s average lifespan for a 55-year-old female. Once done, I could then run the same calculations I ran for Cheese’s buyback scenario and compare apples to apples.

I sent the following results to Cheese:

Using your payback math, with those 5-years of $24,750 in net payments and 24 years of net yearly payment increases of $7425 (assuming a life expectancy of 84 years old), your wife’s annual average net pension payment increase is $10,312. That’s a whopping 60% increase over your wife’s baseline $17,325 annuity payment!

The average annual rate of return from 55 to 84 for buying those years with $150K is 6.9%. I calculated this by determining the rate of return for the first 5 years of retirement, where payments net $24,750 annually from your $150K investment, which was 16.5% per year. I then averaged those results with the annual 4.9% rate of return on the remaining 24 years of payments which netted $7,425 annually. The above technique is as close as I could get to determining the impact of those 5-years of balloon payments on the “immediate annuity purchase” scenario I used in your buyback scenario. In other words, your wife’s buyback scenario equates to an immediate annuity purchase with a 6.9% annual rate of return.

The spreadsheet that I used to make these calculations is inserted below:

Now, given that your wife’s pension doesn’t have the same type of COLA as yours, we need to consider inflation on that rate of return. Assuming the worst case, that the state legislature doesn’t pass any COLA increases, seems extreme. Taking the opposite stance that they always provide a COLA also seems unwarranted. So, let’s knock 1% percent off of the historical inflation average due to the intermittent COLA, and assume a 2% annual inflation rate. In that case, your wife’s buyback has the same return on investment as an immediate annuity with a 4.9% real rate of return. That’s OK but not as good as yours.

Regarding investing the buyback money, my calculations show a 79% chance that $150K otherwise invested in the S&P500 could support annual withdrawals of $10,312 from age 60 to 84 in a volatility scenario. Again, that’s based on FRP’s rather high average S&P500 returns (12.3%) and volatility (20.2%) with a 3% inflation rate and a +/- 2% deviation range. My calculations also include her working in the 5 years between 55 and 59 as envisioned in option 3′ sage 60 retirement start. This means the invested money would have accumulated returns before you and her tapped them.

See my calculation screenshot below:

Thus, assuming she lives to 84, buying back years will provide the ability to bring in an average of $10,312 more annually, but with less risk than investing it in an S&P 500 index fund. This decrease of risk is less pronounced than your buyback but still significant.

Buying Years or Buying Freedom? 

With all the numbers laid out in front of me, I did not see any red flags that should prevent Cheese and his wife from buying back 9 years in her pension plan. In terms of efficiency, Cheese’s real rate of return compared to his wife’s (e.g., 6.7% compared to 4.9%) is better value for money. However, the increase of Mrs. Cheese’s average yearly pension payments by roughly 60%, compared to Cheese’s 30%, mitigates that argument somewhat.

On the plus side, both buyback scenarios offer(ed) a healthy reduction in risk compared to the alternative scenarios. In other words, investing the money themselves and replicating the annual pension increases through withdrawals from those investments is a lot riskier. This is especially true since both pension plans are so well funded.

Yet, unlike his wife’s, Cheese’s buyback scenario didn’t unlock a transformative ability for him to retire 5 years early. Remember, Mrs. Cheese was “truly done” with teaching. The stress of the past few years (i.e., education during the COVID pandemic) had ensured that. So, how much would you pay to get five work-free years back into your life?

That last question is meaningful because it’s the entire point of this website. However, it’s not even a technically valid question. I say that because Cheese and his wife aren’t actually paying $150K to buy five years of freedom. They’re investing for it! Remember, the investment pays for itself in roughly 9 years. Assuming Mrs. Cheese lives that long, the buyback would actually cost nothing! Even if she doesn’t live that long, she would probably rather spend those years enjoying retirement than working a job where she dislikes the bureaucracy.

The Final Verdict

The above insights led me to write the following to Cheese in our final exchange:

The numbers align with you and your wife’s values (i.e., believing that early retirement is the best option for her mental/emotional health). As someone who retired at the earliest possible moment from his pensionable job for the same reasons, I can honestly tell you that I don’t regret it for a moment. I would have gladly paid $150K for a 60% increase in my pension’s annual value and the ability to leave just three years early, let alone five!