The Set Up

A reader (let’s call her Buffy) recently asked me if I could help her and her husband (let’s call him Angel) determine if “buying years back” from Angel’s pension would be worth it. For those of you unfamiliar with the concept of “buying years back”, it basically means under certain circumstances a worker can pay the pension fund to add years onto their final pension calculation. I only learned of the concept of “buying years” after starting this blog. Although the concept appears common in many European retirement systems, and the Canadian national system; the feature is reserved for public pension systems at the local, state, and (non-military) federal level in the U.S. The worker usually qualifies through special circumstances like prior military service (that fell short of pension eligibility), or previous participation in a separate public pension system (e.g. a teacher who moves from one school system to another).

The Pros

The main benefit of buying back time is that upon retirement, it appears that the employee worked more years than they actually did. For example, if someone worked 22-years, but buys back 3-years, then their final pension calculation uses 25-years as the basis to calculate the annual pension amount. In a system where the number of years worked factors heavily into the final salary calculation, “buying years” could mean a serious increase in a person’s annual pension.

In some cases, “buying years back” may also come with less tangible benefits. It may make an employee eligible to retire earlier. This could be a huge but intangible positive for anyone in a gutting it out situation like I described in my previous post. In some situations, a worker who “buys years back” may qualify for full healthcare benefits alongside their early retirement eligibility. Thus, the conventional wisdom I found in researching this issue states that in most cases buying extra years is the smart move.

The Cons

There are, of course, caveats. First, there is a cost to buying back those years. In Angel’s case, it’s currently $10K per year for up to 6-years of previous military service. It turns out that Buffy and Angel don’t have $60K just laying around. Who does? As a result, Buffy and Angel would need to take out a loan. Since loans mean interest, the cost will end up higher than the $60K price tag. Fortunately, Buffy’s on top of things fiscally and sent me the details of the loan offer. I include them in my calculations below.

Buffy’s also locked-on enough to understand there’s an opportunity cost that goes beyond the simple issue of a loan with interest. In fact, Buffy specifically asked me if she and Angel would be better off not buying back the years, but investing the same amount of money they’d make in monthly loan payments into the 457 offered by Angel’s employer instead. Fortunately, there’s a way to figure all of that out mathematically, and Buffy’s supplied me with all the information to run the calculations below.

Pension Safety

Finally, I’d be remiss if I didn’t point out an issue I identified with the conventional wisdom. Most of the information about pension buybacks I found on the internet seems geared towards a buyback of years within the U.S. Federal Retirement System (FERS) or the national systems of Canada or the United Kingdom. When considering a buyback into FERS, pension fund safety isn’t an issue, if one assumes the U.S. will continue to pay its debts. I think that’s a safe assumption because if the U.S. ever stopped paying its debts, the world’s current financial system would collapse. I think that’s a safe assumption for Canada and the UK as well. However, that same assumption cannot be made for state and local governments in the U.S.

As I explained in my Pension Safety post, my general rule of thumb is that the further down the U.S. government scale a person’s pension fund falls, the more uncertainty it injects into the safety calculation for that pension. Now, that’s just a general rule of thumb. In many cases, county or city pensions are better funded and managed than state pensions. Yet, I researched the funding levels for Angel’s pension system, and as of the end of 2017, its funding ratio was 80% of future projected liabilities.

Funding Ratios

To be clear, that’s not a great funding ratio. Although, 80% is the de facto dividing line in the U.S. between pension funds described as healthy or unhealthy, that standard is rather arbitrary. In 2012, the American Academy of Actuaries (AAoA) produced a report detailing the history of the “mythic 80% standard”. They also described the dangers associated with blanket statements about the health of pensions without considering the future liabilities of each individual pension fund. In other words, EACH PENSION IS DIFFERENT!

That’s a sentiment I actually stated on the ChooseFI podcast based on my independent research. It’s great to see it backed up by an organization like the AAoA who actually does this stuff for a living. In any case, the AAoA’s paper also stated that all pension systems should strive for 100% percent funding against future liabilities. What’s that mean for Angel and Buffy? It means there’s a safety risk with Angel’s pension fund. How much? I can’t determine. I found the pension system’s 2017 financial statement and it’s dense. However, in my completely non-professional opinion, the issue bears consideration in Angel and Buffy’s decision-making process.

Angel’s Situation

Angel is 28-years old, and from what I can gather, only recently started working for this employer. He can only retire with immediate pension benefits after he turns 50. However, he must also work 25-years to earn full healthcare benefits in retirement. That means the earliest he can retire is 53-years old (assuming the pension buyback doesn’t calculate into the health care coverage requirement). There is up a to a 2% Cost of Living Adjustment (COLA) each year on the pension total as well, if required, due to inflation. All in all, despite the 80% funding level, I consider this a Cadillac pension plan. I can see why they’d want to buy more years into it.

The pension fund uses both retirement age and the number of years worked for the final pension calculation. The buyback affects the total years worked portion of the equation. As mentioned above, Angel can buy up to six years back at $10K a year, which is what he intends to do. He and Buffy are currently contemplating a 10-year fixed loan at 7.25% interest rate to finance the 6-year buyback. The terms include a $689 monthly payment with total interest calculated at $21,391. Thus, the total cost of the buyback would be $81,391.

Angel’s Intention

Angel intends to retire as early as possible, so Buffy ran the numbers for 25-years worked, with and without a buyback, using the pension fund’s online calculator. Here’s what she sent me:

If he does 25 years of service and retires at 53 years old, he’ll get about $55,200. If he buys back 6 years at 53 years old, he’ll get $68,439.

That’s a $13K difference per year in retirement, which quickly adds up. In fact, even with the loan interest taken into the consideration, the buyback would pay for itself after 6.15 years of retirement. In other words, Angel would only have to live for 6.15 years into retirement to break even on the investment.

The 457 Plan

Of course, Buffy didn’t ask me to help her calculate the break-even point for the loan. She asked me to figure out if she and her husband would be better off foregoing the pension buyback and investing the equivalent of the monthly payments of the loan ($689) into his 457 plan instead. To answer that question, I had to dig into the details of the 457 plan for her husband’s retirement system.

For those of you unfamiliar with 457 plans, Investopedia defines it as:

… a non-qualified, tax-advantaged deferred compensation retirement plan. Eligible employees are allowed to make salary deferral contributions to the 457 plan. Earnings grow on a tax-deferred basis and contributions are not taxed until the assets are distributed from the plan.

Some of you may be thinking it sounds a lot like a 401K retirement account for public employees, but it’s not. A 403(b) is the public employee’s equivalent to a 401K with the same contribution limitations ($18K per year), tax-deferred status, and early withdrawal penalties as a 401K. Since a 457 plan is technically deferred compensation, it means there are no early withdrawal penalties. There are some other cool perks to the 457 too, but for Angel who intends to retire at age 53, the lack of early withdrawal penalties (i.e. 10% penalty on any withdrawal before the age of 59.5) is the main planning factor.

457 Problems

The problem with 457 plans is that they have a justified reputation as lousy investment vehicles with bad investment choices and high administration costs. Luckily for Angel, that’s not the case for his 457 plan. I did some research and it’s monthly administration fees are less than $5 a month. I also found an S&P 500 index fund in his plan with an administration cost of .01%. This is perfect since I routinely use the S&P 500 as the benchmark for my investment calculations. The minimal administration fees mean that I won’t need to take them into serious consideration during my calculations.

Running The Numbers

Speaking of calculations, let’s talk methodologies and then run some numbers! The most important thing to note is that in order to come to a projected investment value, I must make two different calculations. The first calculation is a Future Value (FV) calculation in Excel which will determine the value of the investment after 10 years of monthly ($690) payments invested into an S&P 500 index fund at the S&P 500’s historical rate of return. Since I use 7% as my standard inflation-adjusted historical rate of return for the S&P 500, my FV calculation looks like this:

=FV(7%/12,120,-689,,1)

Which projects a total FV of $119,951.09.

However, that’s not the end of the investment period, simply the end of an equivalent 10-year period of monthly investments that match the loan payments. There’s still another 15-years to go until Angel retires. Thus, the next step is to calculate the next 15-years’ worth of dividend re-investments and growth that the investment would experience. Fortunately, my 7% average return for the S&P 500 incorporates dividends. Thus, all I have to do now is change the values in the FV formula to calculate the return over the 15-year period, without the monthly investment payments, but including the $119,951.09 lump sum. As a result, my FV formula should look like this:

=FV(0.07,15,0,-119951,1)

Which projects a total FV of $330,948.84.

Is It Enough?

There are several ways we could try to determine if the roughly $331K saved and invested is enough to sustain withdrawals worth the difference between a 25-year pension, and a 25+6 year buyback pension. As I pointed out above, the difference between the two pensions is roughly $13K, or $13,239 to be exact. Interestingly enough, $13,239 is exactly 4% of $330,948.84. So, if you’re of the opinion that the 4% Safe Withdrawal Rate (SWR) is alive and well, then one could simply call it a day and say that investing is the better option.

However, if you’ve followed my blog for any amount of time, you know that I subscribe to the theory that the 4% SWR is too optimistic. I believe that a 3.5% SWR is far more realistic to use for people’s retirement calculations, based on the work done by Big ERN over at the Early Retirement Now blog. Thus, by taking $13,239 and dividing by 3.5% I find that Buffy and Angel would need $378,257.14 saved and invested by age 53 to safely generate the increased amount of income from the 6-year pension buyback.

Now to the untrained eye, the $48K difference between the nest egg required to enact a 3.5% versus a 4.0% SWR may not seem like a lot, but it’s almost a 15% difference. That 15% difference decreases the probability of success in this spend-down scenario quite a bit when I load it and run it through my preferred retirement simulator, Flexible Retirement Planner (FRP). Without simulating market volatility, the likelihood of success that $13,239 proves sustainable, drops from 100% when starting with a nest egg of $378,257.14 to 80% when starting with a nest egg of $330,948.84.

Speaking of …

Speaking of market volatility, up to this point, none of my calculations or formulas took the potential for market volatility into account. The 7% average return I used for the S&P 500 above to calculate the future value of Angel and Buffy’s 457 plan is a constant in the FV formula. Yet, as we all know, that’s not how the stock market works. Some years it’s up 20%, some years it’s down 15%. Those swings are called volatility. Most importantly, at what point in an investment’s life cycle volatility occurs, can dramatically alter the final value of the investment, and its ability to sustain withdrawals.

Fortunately, I can simulate the SP 500’s volatility with a high powered retirement calculator like FRP. In fact, I can model volatility across the entire scenario, both in the accumulation phase and in the spend-down phase. Unfortunately, when I do this, the projected accumulated value of the 457 plan (prior to spend-down) is greatly decreased. This, in turn, drastically decreases the probability that withdrawals of $13,239 a year are safely sustainable for a significant length of time. As a result, when I model this entire scenario until the age of 80 (the average for male longevity in the U.S.) FRP calculates only a 49% probability of success. The snapshot below represents the average portfolio value based on thousands of simulations within FRP and clearly depicts the rise and fall of the portfolio’s value during the accumulation and spend-down phases.

So Is That It?

For the most part, that is it for what the formulas and simulations can tell us by themselves. On paper, it appears that the six-year pension buyback is a good deal even with a 7.25% loan. However, there are three issues worth considering in my mind. One is a pro, in favor of the buyback, but the other two issues are cons against the buyback. Let me address the pro first.

The pro is something I brought up to Buffy already, and it centers on the fact that I think they could find a cheaper loan elsewhere. I specifically asked if she and Angel could secure a home equity loan for $60K, and if they could, what the rate would be. She thought they could, and stated the rate their bank keeps sending them through the mail is 4.5%.

That’s a significantly cheaper interest rate than 7.25%, and it would save them thousands of dollars in interest payments alone. Thus, a buyback looks all that more (financially) attractive in my mind if they use their home equity. However, Buffy mentioned that she and Angel wished to move their family of five at some point into a bigger house. I told her if they can’t delay that move until after the home equity loan is paid off, then they shouldn’t use home equity to buy back the pension years.

The (Decepta)Cons

Now, to the cons against a buyback. As I stated up top, Angel’s pension fund is 20% under-funded against future liabilities. As a result, I can’t shake the feeling that spending $60K (plus interest) to buy 6-years into underfunded pension system is a good idea.

If I were to (completely unscientifically) translate the pension fund’s lack of funding into a 20% probability that it won’t pay out Angel’s full retirement, and then reduce by 20% the $13,239 p/y his buyback earns to $10,591; then the 457 option looks a lot more competitive. In fact, $10,591 divided by a 3.5% SWR equals $302,605 as a required nest egg. That’s well below the nest egg calculated above using the FV formula. On the other hand, when I use the volatility simulation in FRP, even with a reduced withdrawal requirement, it still only calculates a 60% probability of success.

That said, when I consider the above (somewhat) tangible con, with this slightly intangible one, the buyback appears even less desirable in my mind. Granted, what I’m about to say is tinged with my Golden Albatross experience of suffering a mental breakdown 16 years into a 20-year pensionable career — and wanting to quit — so take it with a grain of salt. However, 25 years is a long time for anyone to work one job, especially a public safety job like Angel’s. So much could happen from the physical to the emotional to the psychological, that it seems premature to lock up $60K (plus interest) in a pension buyback at this time.

Conclusion Part 1

It’s clear to me that pension buybacks can be a powerful tool for some folks who find themselves eligible for it. I’d say in many (possibly most) cases, the math will probably favor the buyback. I can definitely see how a buyback into a safe fund can help a person achieve Financial Independence (FI). But, as a person who usually advocates for staying with the pension annuity options when the numbers clearly favor it, I now find myself in the unusual place of counseling caution.

If it were me in this specific case, I’d wait and see how the career develops and let some of the intangibles surrounding this situation play themselves out. Buffy relayed to me that delaying the decision is possible, the only issue is that the price for the buyback keeps going up. However, knowing what I know after 19 years in a demanding pensionable job, that’s a price I’d be willing to pay. In the meantime, I’d start saving into the 457, reaping those tax-deferred benefits, and utilizing the low-cost index funds.

Conclusion Part 2

However, I’m not Buffy or Angel, so they will need to make this decision for themselves. My recommendation values the flexibility that a delayed decision coupled with tax advantage savings provides. They may value something different. They may just want to make this decision, and get on with the rest of their lives. Certainly, on paper, the math works in their favor, and I wouldn’t fault them for buying back the years. If the pension were 100% funded, this decision would be a no-brainer. Unfortunately, it’s not though.

Truly, this decision must come down to Buffy and Angel’s personal preference. I believe I’ve done a fairly good job of examining both the math and art of this particular pension question and FI issue, which is what this website’s all about. Yet, I can’t make the decision for them.

Good luck to Buffy and Angel. Thank you for reaching out and I hope you found this useful!