Substantive Revision

This is a substantive revision to the original Pension Series Part 19 article I published on 23 June 2019. I updated this article because I have a new method for calculating the Total Dollar Value (TDV) of pensions that do not possess a Cost of Living Adjustment (COLA). The new method is far more accurate than the old method, so I am updating all articles in which I used the old method.

I notified BrewDog (the subject of this article) and provided him with updated Master Pension Calculator spreadsheets that utilize my new method. I did this because the TDV of his no COLA pension changed significantly when I used the new formula. As a result, I also updated the two spreadsheets embedded in this article and some of the text. If you downloaded the old spreadsheets, delete them, and download the new spreadsheets with the new formula. The text changes are noted in blue below and include strike throughs of the original article’s verbiage when needed. I kept the italicized format for the verbiage cut and pasted from newer emails between BrewDog and myself. 

My apologies for any inconvenience this update may cause, or already has caused. I’m well aware that the updated version of this article no longer reads as clean and easy as the original post. However, I’m committed to ensuring the information shared on this blog is accurate. As a result, when new circumstances alter the accuracy of an old post, I feel obliged to update it, even at the expense of readability.      

If you want more information on why I updated the TDV formula for no COLA pensions, you can go to Part 4 of the Pension Series for the abridged version. That is the source article for all my TDV calculations, and as such I updated it first. If you’d rather read a more in-depth explanation about the impacts of inflation, and the correct way to incorporate it into TDV calculations, then you’ll need to wait for my book, “The Golden Albatross: How To Determine If Your Pension Is Worth It“. It’s currently scheduled to be published in early 2020 by ChooseFI publishing.

This Never Gets Old

I’m not feeling particularly creative or productive this weekend. The last two weeks flew by in a blur due to work, which means no work on retirement paperwork. Strangely, though, I found both the time and mental clarity to help a reader analyze his pension lump sum choices. It was a conscious decision on my part. I like helping people, and given the situation with work, I just felt like saying “F-it, instead of crawling into bed, I’m going to wrench back some control of my week and help someone because it feels good.”

That said, it sapped my last creative energy for the week. Mrs. Grumpus would probably argue that I should’ve saved that energy for the family. But, since she doesn’t read the blog, let me confide that the nightly battle of wills between me and four-year-old Grumpus Minime #2 (pronounced min-EE-me) over showering, reading, and going to bed on time, aren’t nearly as rewarding as helping a stranger.

However, because I spent all my energy earlier in the week, it also means this article isn’t anything fancy. In fact, it’s mostly a cut, paste, and edit job from all the emails my reader and I exchanged about his pension. I edited for grammar and threw some original thoughts in between his request and my analysis, but that’s about it. Does that make me a lazy blogger? No comment, but I think the exchange and the discussion over the results create worthy reading material regardless. It’s especially helpful for anyone with a pension lump sum decision to make in the future.

BrewDog’s Dilemma

First off, I’m calling my reader BrewDog. His name reminds me of a great string of pubs I drank at when stationed in Europe with the same moniker. Why don’t I let him tell you the rest?

I worked for this company for a number of years, but they laid me off. Unfortunately, I missed the lump sum option at the time. Frankly, I wasn’t even aware I had or was eligible for a pension until I got the letter in the mail. 

I basically have 4 options:

1) Early Lump-sum in 2021 (55 yrs.) $126,452

2) Early lifetime payments in 2021 $617 monthly

3) Retirement Lump-sum in 2031 (65 yrs.) $203,857

4) Retirement lifetime payments in 2031 $1,234 monthly

The pension looks straightforward. There is no COLA adjustment, no medical, or any other supplemental benefit. It’s just straight cash payouts. 

My two main concerns are:

1) Pension remaining solvent. I have seen it go from 100+% funded to its current 97% in the past few years. My gut feel is to take it while it’s still there.

2) Taxes. My lump sum vs. monthly payout decision will depend on how the pension is distributed. I’m assuming it’s regular income, and that a lump sum payout would generate a pretty significant tax hit. Yet, I’m willing to take it if it makes financial sense.

I’m not in a position where I “need” the money. But, it’s large enough to pay attention to. I’m also in excellent health so no concerns about checking out early unless my current job stress puts me under. My current age is 52. I would be 55 in 2021 at first early pension option. Longevity probably mid-80s or so. I’m very healthy, have a great diet, exercise, etc. so would expect to be on the long tail side [of longevity]. Living until 85-86 would be my WAG [wild ass guess]. 

In the past few years, the funding [for the pension] seems to have decreased by a percent each year. Not overly alarming but would concern me as more of the “older folks” begin taking their pensions. I don’t know what the company’s ability (or maybe, more importantly, their commitment to) additionally funding the pension. It’s a typical Fortune 50 corporation focused primarily on their own bottom line. So, my guess would be they could, and would, fund any pension shortfalls but only if it didn’t impact their bottom line and/or investor relations too much.

This is a single-employer pension. They’ve gone through the typical M&A over the years, and will likely continue to do so. So, sub-companies may continue to come and go in the future. The pension is simply the parent though. I do not know if they even offer a pension anymore. There are unions at various manufacturing facilities but their pensions would be separate and managed by the various unions. 

Thanks, Grumpus.

A Few Words About BrewDog’s Situation

Don’t fool yourself into thinking BrewDog provided all of the above information in one go. It took a few emails and messages to tease all of it out. However, if you want me to help you analyze your pension lump sum options, take note! The above is a great example of all the information you should provide.

With that in mind, let me also say that BrewDog’s situation is fairly common. He’s got access to a future pension that’s no longer growing in value (because he doesn’t work there anymore), he’s concerned about the future financial viability of the pension fund, and he’s leaning toward taking a lump sum. What BrewDog doesn’t know is how much money he’s potentially leaving on the table by taking a lump sum.

As we all know from reading Parts 8, 11, and 12 of the Pension Series, you always leave money on the table if you take the lump sum. The actual calculations to determine how much won’t be too tough since BrewDog mentioned there are no Other Earned Pension Benefits (OEPBs) like healthcare. The real issue may not be how much money BrewDog’s leaving on the table, though. The real question may be what BrewDog think he gains from taking a pension lump sum?

Belief Can Be Great and Dangerous

Many Financially Independent (FI) minded people believe they can take a lump sum, invest it, and earn a Return on Investment (ROI) that equals or betters the future value of the pension’s annuity. They may also believe that if they’re in control of their money and invest it well, they can pass it onto their heirs. I don’t know if that’s BrewDog’s intent or not, he didn’t get that specific. Truthfully though, no matter who you are, earning an ROI that’s better than a pension annuity is a tall order. Anyone who thinks they can do it should check out the latest Dalbar report. Most people suck at investing.

BrewDog seems more concerned with the pension fund’s long-term viability than he is with controlling the money. I know that because he said it … twice. If a person believes that the future viability of the pension fund is at risk, then it often acts as a trump card over many, and probably all, other concerns in the lump sum calculus. That’s the way BrewDog is leaning because, again, he told me.

A lot of people take the lump sum as quickly as possible because they don’t believe it will be there later. But that belief comes with a cost. In fact, as I recently wrote in my forthcoming book, The Golden Albatross:

By offering the lump sum, the pension fund is legally stating that they can’t guarantee they’ll be around in the future to pay out. Thus, they’ll pay you now. However, since they’re doing you the favor by paying you a guaranteed amount now versus an unguaranteed but legally calculated amount in the future, they’re going to charge you for the convenience. In other words, they are taking some off the top for insurance, and like most insurance of this type, it isn’t cheap.  

Pension Risk Transfer Never Gets Old … Either

On the surface, BrewDog’s not wrong to worry. In Part 1 (Pension Safety) and Part 15 (The Pension Benefit Guarantee Corporation (PBGC)) of the Pension Series I point out a multitude of issues surrounding pension safety. In fact, the risks involved with managing a long-term pension fund is why so many corporations are paying insurance companies to take future liability off their hands. They do it through a process known as Pension Risk Transfer.

That said, BrewDog shouldn’t overemphasize the safety issue with his pension. At 97% it’s still well funded by most U.S. pension standards. But, as the American Academy of Actuaries pointed out in 2012, the funding trend is more important than the funding level. So, it’s worth keeping an eye on, especially if the downward trend picks up. On the other hand, as I pointed out in Part 15 of the Pension Series, Single-Employer Plans (SEPs — the same type as BrewDog’s) are backed by the fully funded part of the PBGC. Which means even if his pension fund tanks, the PBGC’s SEP fund would step in and fund a large portion of his pension.

Honestly, though, I don’t think it will come to that. BrewDog’s pension fund seems ripe for a Pension Risk Transfer. It turns out that in the weeks since he sent me his email, his former company was itself identified as the target of a merger. I read about it in the Economist. If that merger goes through, my suspicion is that the pension fund would probably be transferred to an insurance company. That’s not a bad thing, because as I point out in Part 14 of the Pension Series, transfers to an insurance company almost always work out well for the pensioners in a plan.

The Real Question

What BrewDog needs to ask himself is whether or not he’s ready to take on the risk that accompanies a lump sum? Transfer of risk also happens when someone takes a pension lump sum. But this time, the pension fund is transferring the risk of running out of money to the individual instead of an insurance company. Unlike insurance companies though, the individual doesn’t get to charge a premium for the transfer of that risk.

As stated above, an individual who takes a lump sum payout actually gets slapped with a penalty. Call it a convenience charge, or a tax, but either way, the pension fund always ends up transferring less money to the individual than what the individual would make by living a long life and taking the annuity. Keep all of that in mind as you read through my analysis of the situation below.

Master Pension Value Calculator to the Rescue

BrewDog, I ran your numbers using my master pension value calculator (attached) for both the 55-year-old scenario and the 65-year-old scenario. If you’re not familiar with this spreadsheet, it’s embedded in Part 13 of my Pension Series on my website. That article basically teaches you how to use the spreadsheet.

The reason I bring up my article is that it explains how subjective the output values [in the calculator] can be, based on the numbers a person pumps into the first tab of the spreadsheet. This means it’s in your best interest to get familiar with the spreadsheet and determine how the required inputs change the various formulas and final values. You’ll notice that no two methods produce the same output, so this is very much a judgment call on which valuation formula(s) you believe are the most accurate for your specific situation.

The article also explains how I don’t necessarily endorse all the various valuation methods encapsulated in the spreadsheet. In fact, since I wrote that article, I’ve come to believe that the Financial Samurai method is wildly outlandish, and I typically ignore it when I’m running someone’s numbers.

More Caveats About the Calculator

A reader with some serious spreadsheet skills put the calculator together based on all the different pension valuation articles he read. He also added one of his own methods as the last tab. I tweaked some of the tabs but left the formulas mostly unchanged. So again, there’s some serious subjectivity here, and you need to figure out which tabs are the most applicable.

Much of the decision on which formula to use will come down to what you believe your future numbers will look like. By that, I mean numbers like your annual average investment returns or return on investment, your longevity, the likelihood of your pension paying out, and inflation. Depending on what you put into those boxes on the front tab, some values begin to look better than others.

Specific Inputs for BrewDog’s Situation

With all of that said, I used the following numbers (for the following reasons) in the more subjective categories:

Life expectancy – 90 (because you said you were fit, and I’m conservative, so you living to 90 is a worst-case scenario from a fiscal standpoint that I wanted to plan for).

Expected market return (prior to subtracting inflation) – 7% (more conservative than your standard 9% return before inflation associated with the S&P 500’s average return because we’re in a weak return environment based on market fundamentals).

Reasonable Rate of Return / Discount rate – 3% (that should probably read Safe Return Rate because the best value to use is a projected CD or government bond rate – with that said 3% seems generous considering how low interest have been lately).

Probability of your pension paying out – 97% (based on your statement that it is 97% funded. My rule of thumb is to discount this value percentage point by percentage point based on funding levels of a pension).

Estimated future inflation – 2% (that’s the Fed’s target rate, but inflation remains low even though we’ve been in a Bull market / economic expansion since the Great Recession. So, you could put it lower if you believe the low-inflation/low-interest rate environment will continue).

The Overall Results

OK, here are the results. 

For the age 55 scenario, the lump sum is fairly competitive if you use my (Grumpus Maximus) tab’s method. According to my calculations, your lump sum will only be about $3K short of the Total Dollar Value (TDV) of your annuity at age 55. Some of the other tabs show a bigger gap between the value of your annuity and lump sum in favor of the annuity.

I’ve reworked the two master pension spreadsheets with your information based on the new formula. They are embedded [below]:

Bottom line, the new formula changed the estimated value of your pension annuity options upwards by roughly 30% in the age 55 scenario and 22% in the age 65 scenario.

According to the calculations your updated Total Dollar Value (TDV) values are:

Age 55 Scenario = $183,910.50

Age 65 Scenario = $287,722.82

I’ve added the new formula at the bottom of the “Grumpus Maximus” tab in each spreadsheet, so you can see how I calculated the values. Both TDVs are now significantly higher than their lump sum counterparts, which is what I expected, and why I contacted you for follow-up.

GM Comment: In fact, my new calculations show that the TDVs are roughly 30% greater thaan the lump sum offers. 

The Age 65 Scenario

The age 65 scenario is where the numbers really start to open up in favor of your annuity. In other words, the pension fund is offering you a lot less in the lump sum than what you’d earn from your annuity (assuming you lived to 90). The calculations show a $21K difference. Other valuation methods on various tabs show a lot more. 

None of this should be shocking. As my original pension lump sum article (Part 8 of the Pension Series) points out, there are several built-in advantages in the data that the U.S. government requires employers to use when calculating pension lump sums.

More Analysis of the Lump Sum Spend to Zero Scenarios

Possibly the most important thing to note, is that by using the 4% rule (of thumb) Safe Withdrawal Rate (SWR) your age 55 lump sum offer is short about $60K from being able to reproduce the monthly ($617) or annual ($7404) payout value of the annuity. Which means you couldn’t pull out nearly as much money from the invested lump sum on a monthly or annual basis as the annuity would pay you.

That assumes you want some money left over at the end of your retirement. If not, and you don’t mind running your lump sum value to zero by the time you die, then my calculations show that you can withdraw the equivalent of your monthly ($617) or yearly ($7404) for the age 55 scenario annuity from your invested lump sum (earning 7% rate of return) and it would last 34 years. The spend to zero scenario [for age 65] wouldn’t last you nearly as long, approximately 22 years based on my calculations.

All of that said, having re-looked at your scenario in total, and having just spent two months deep diving on pension valuation and lump sum mechanics for my book, I **think** I understand how your pension fund calculated the lump sum offers. You may have already figured this out, but the key to understanding the lump sum offers is not in the TDV calculation, but in the spend to zero scenarios as stated in the bottom left hand yellow box on the “Grumpus Maximus” tab.

No pension fund is going to offer a pension plan participant a lump sum that would (after being invested) kick-off more money through returns and dividends than what you would have otherwise received via your annual annuity offer. In other words, they assume you’re going to invest the lump sum, obtain a “reasonable rate of return”, withdraw the same amount annually as the annuity, and die with exactly zero left in the account.

What you don’t know though is what they see as a “reasonable rate of return”, nor do you know what they used as life expectancy. Is a reasonable annual rate of return the S&P 500’s historical pre-inflation average return rate of 10%? Or the Dalbar report’s pre-inflation return rate of 5%? Is it reasonable to expect you to live until 90, or until the average American male’s 78.69 years (Source: 2016, World Bank)?

New Insights From This Fresh Look

You’re in the ball park though with the 55-year-old lump sum scenario. I happened upon a combination of life span (dead at 90, 35 year retirement) and investment return rate (a post-inflation (real rate) of 5%) that would see your lump sum (after investing) running out in 34.4 years. Now, I don’t think those are the values they used. If I had to guess, they probably used the inverse. By that I mean they probably used a much higher investment rate of return, and a much lower expected life-span, and therefore planned for you to have a much shorter retirement.

Don’t take that personally. Estimated life-spans for pensions are dictated in the U.S. by certain Federal guidelines, and are much shorter than the 90 years I used. In fact, as of 2017 (the last time I researched the issue in depth) Federal guidance actually forced pension funds to combine men and women’s life expectancy together. Oddly, that works out in men’s favor since compared to women they live shorter lives. However, even the combined average is shorter than 90 years.

On the “reasonable rates of return that pension funds can use for lump sum calculations” issue, my understanding of Federal guidelines is that they are fairly lax. Meaning pension funds can use rather high projected rates of return for their lump sum calculations. That translates into a smaller lump sum offer for you. Although, again, I haven’t researched that specific issue in a few years. The rules may have changed, but if they have, I haven’t seen any articles about them. 

What I think you could do, if you’re inclined, is fool around with the expected retirement life span and rate of return numbers in the spreadsheets, and figure (roughly) what the pension fund used for those two values. By doing that, you will then know what rate of return you would need to either achieve, or surpass, their spend to zero scenario.

Let me know if this stuff makes sense, or if at this point I’m just babbling. It’s late here, and I’m tired.

Taxes

It’s important to note that none of these calculations take taxes into account for either the annuity or the lump sum. I noted your original email asked about taxes and lump sums. Typically, an individual can roll their lump sum into some form of a tax-advantaged retirement account. Which type (Roth or Standard 401K) really depends on the pension.

For instance, did you contribute to this pension? If so, how were those contributions treated for tax purposes when you made them? The answer will possibly dictate the type or account your lump sum could be rolled into. That said, there are some pensions that don’t offer the ability to roll over into a tax-advantaged account. I don’t know what that dividing line is, or why, so I would certainly check with your fund’s administrators or a CPA.

One Follow Up Point

BTW, you may want to check your annual pension statement to see if it lists funding for Other Earned Pension Benefits (OEPBs). OEPBs are things like healthcare attached to a pension. I found an S&P 500 report from 2017 for all S&P 500 companies with a pension fund, and it sure made your company’s pension seem a lot less well funded when OEPBs were taken into consideration. Now, the thing about OEPBs is that a company can simply stop paying for those. They’re not legally obligated to pay them unlike the actual pension [annuity]. I know you mentioned that healthcare wasn’t involved in your pension, but others who joined earlier, or stayed longer, may have it attached to theirs. Food for thought when you’re considering that lump sum. 

My Final Pension Lump Sum Thoughts for BrewDog

OK, that’s about it for me. Again, I strongly suggest that you play around with these numbers and the various formulas. Determine which ones you’re most comfortable with. Some other things that you need to think about and that only you can answer is what your priorities for this money will be. Do you want this money to pass on to heirs? Or do you want it to be at zero by the time you die? Those weren’t details you supplied, but don’t feel bad, because most people don’t. That’s why I built in the option to tinker with that idea into my tab on the spreadsheet.

I hope this analysis proved useful. It’s been a while since I’ve done one. I had to knock off some mental rust and remember all the ways I’ve done this in the past. Also, I hope you don’t mind but I’ll probably give you a code name and make an article out of my analysis of your situation. I won’t mention anything that could identify you like the name of your company. You can pick the code name or let me dream something (hopefully) funny up. 

BrewDog’s Final Thoughts

Thanks A LOT, Grumpus. It will take a while to digest what you’ve worked on. Apologies I didn’t realize it was this involved. Thank you again for your help though! And yes, I am a fan of Financial Samurai but sometimes his numbers are a little funny. Must be a West Coast thing.

Yes, that would be fine if you want to make a post out of my situation. Let me know if you have any further questions. Interesting with the OEPBs. It sure adds weight to the “get while the gettin’s good” lump-sum view. I wanted to “buy you a coffee” but am not seeing it on your blog. Is there something I can do as a “thank you” for working through this? Thanks again.

My Gift Policy

BrewDog, thanks for the offer, but I like helping people which is one of the reasons why I haven’t set anything up. I usually settle for people’s permission to use their story for a post. That said, I’m trying to publish a book at the moment. If and when I publish it, please tell all your pension potential friends about it and my blog. Actually, you can tell them about my blog now, and the book in the future. That makes more sense!

BrewDog’s Final Thoughts On My Update

Interesting how the new TDV calculations are a lot higher. I still like the idea of lump-sum early, then reinvesting in cash flow investments. I’ll need to look at the numbers on my end to compare. And, a lot really depends on how the lump sum is distributed (taxed vs non). Thanks again for your help. And good luck with your book! Please reach out if you need anything from me.