Defined pension plans are quickly becoming a thing of the past. And companies continue to reduce or eliminate pension plans. Have you been offered a pension buyout recently?
I worked for General Electric for a little over five years. I received a buyout offer for my GE pension recently.
While I will discuss it from my perspective, the reasoning applies to buyout offers from other companies as well.
Full disclosure: I am not a financial planner nor a tax professional. What I am providing you here is my opinion and items I considered when making my decision regarding the GE pension plan buyout. You should consider consulting with a tax/retirement advisor before you make any decisions regarding a pension buyout.
I'm going to describe the basic layout of the GE buyout. After that, I'll give a pension buyout offer example. Later on, I'll explain how you can estimate the approximate current value of your pension.
But before I get into the details, here is a short explanation of the structure of the GE pension.
GE Pension Plan
The GE Pension Plan has two components (these may vary based on the time of service at GE):
- Company-provided benefit
- The typical defined benefit is in the form of a monthly annuity. The amount is based on how much you earned while working with the company.
- Contributions and Interest
- This portion consists of two accounts
- Personal Pension Account (PPA) – Required contributions and interest earned.
- Voluntary Pension Account (VPA) – Voluntary contributions and interest earned.
- This portion consists of two accounts
Outside of a pension buyout offer, the company-provided benefit annuity is available to start as early as the month after your 60th birthday. The annuity amount is reduced if you start your pension before you turn 65.
After leaving the company, you have three options for the Contributions and Interest portion at any time.
- Leave the money in the plan and convert it to an annuity when you receive your defined benefit annuity.
- Convert it to an annuity
- Take a full withdrawal
Pension buyout offer
The buyout offer had the following sections:
- A discussion of the reason for the buyout
- An explanation of the options including how they were calculated (interest rates and mortality assumptions used)
- A summary of the tax implications of each option.
Buyout offer structure
The offer I received had three options I could make.
- Choice A – Take a lump sum of the present value of the company-provided benefit and the PPA/VPA.
- Choice B – An immediate annuity option. Receive monthly payments equal to the early payment adjusted company-provided benefit and the PPA/VPA converted to an annuity.
- Choice C – A deferred annuity option. Receive monthly payments at retirement from the company-provided benefit and PPA/VPA.
Pension buyout offer example
Here is an example of what an offer may look like for a former employee in their mid-40s.
So based on that, let's look at how much money would be paid out by an annuity at different ages. I included the lump sum for comparison.
Evaluating a pension buyout offer
Let's take a look at the monthly options first.
As you can see, if you take the early monthly payment option, you would be losing out on a lot of money during your prime retirement years.
Additionally, it would take almost 20 years to reach the amount of the lump sum value. However, this will vary based on your age when offered a buyout.
Comparing the “Monthly Payments at Retirement” options becomes a little more complicated.
Depending on your life expectancy, starting your retirement payments before age 65 may be better for you. For the example situation, up until around age 80, the early retirement payments result in more income.
The early retirement payment option is also known as an early retirement subsidy. The payments may be reduced. However, based on life expectancy, any reduction may not fully account for the extra payments.
But if you are considering a buyout at this point, the good news is that you don't need to make that decision now. That decision is made as you approach retirement.
While it may be tempting to take a lump-sum distribution of your pension, you need to consider the pros and cons.
And most importantly, how you intend to use the lump sum.
Here are some questions you should consider:
- What other sources of retirement income do you have?
- Do you have another pension, 401(k), IRA, or other retirement savings?
- Do you have a plan to invest the lump sum?
- Are you rolling the lump sum into an IRA or another employer plan?
- Do you have the knowledge to invest it appropriately?
- Investment risk and fees need to be considered.
- How much time do you have for the money to grow before retirement?
- The most beneficial aspect of retirement saving besides money is time.
- Do you understand the tax implications if you aren't rolling it into an IRA?
- If you’re under 59 ½ and don’t roll over the money into a qualified retirement plan (like a 401(k) or an IRA), a 10% penalty in addition to income taxes will be due.
- What is your life expectancy?
- Not a fun one to consider, but if your family tends to live long lives, a lifetime annuity at retirement may exceed your investing potential.
- Do you want to be able to leave any money left over to your beneficiaries?
- A pension ends when the pension holder and their spouse die. However, if you die earlier in your retirement, you can't leave any of the money that wasn't paid out to your beneficiaries.
Pension buyout rollover options
You have two options for rolling the lump sum into an IRA or employer plan.
- Direct rollover
- The lump sum will be paid directly to the IRA or employer plan.
- No taxes are withheld using this option.
- 60-day rollover
- The lump sum will be paid to you.
- Taxes will be withheld on the taxable portion (20% federal and any state).
- You are responsible for depositing the money into an IRA or employer plan.
- However, you need to deposit the entire taxable portion. Meaning you have to cover any taxes that were withheld. You can recover those taxes when doing your taxes, but you need some money to cover it.
- If you don't complete it within 60 days, you may be subject to the additional 10% income tax if you are under 59 ½.
If you intend to roll over your lump sum, it is highly recommended to do a direct rollover. Doing this will alleviate the tax issues, and you won't have to worry about the 60-day deadline.
Investment potential of the lump sum
Now let's consider what happens if you take that lump sum and roll in into an IRA or employer plan.
Stocks in the S&P 500 index have returned, on average, about 10% annually over time. While there are no guarantees in the stock market, this has been pretty consistent over the long term.
So for the example we've been using, $75,000 invested would provide the following returns.
I used 25 years for the second time frame because at 70 ½ you are required to start withdrawing required minimum distributions from an IRA.
As you can see, you have the potential of growing that lump sum into a much more substantial amount than the pension would pay.
Additionally, you can pass on any of the money you don't use to your heirs.
And the money you haven't withdrawn yet will continue to grow based on your investments.
Running away with your money
If you decide to take the lump sum, keep the following in mind.
- Make sure you are covered for retirement without that money or have a way of making it up. Once you withdraw it, there is no way to put it back.
- Ensure that you understand the tax consequences. I've briefly touched on them above, but I will discuss it further below.
On the topic of a way of making it up…
While you can save money for retirement outside of the typical retirement vehicles like IRAs and 401(k)s, you won't benefit from their tax advantages.
However, if you are using that money from your lump sum to help start a business or begin a path of self-employment, you may have other options.
If you are a business owner or are self-employed and make enough money, you could potentially save up to $56,000 each year (and possibly more with catch-up contributions) using a Solo 401(k) or SEP IRA.
Depending on how much you were saving each year before, you could increase those savings dramatically. These additional savings could have the potential to exceed what you received in your lump sum.
There are a lot of risks involved in this scenario and numerous other factors that come into play. It is an individual decision that needs to be made while taking everything into consideration.
Pension buyout and taxes
I've touched on this a bit above, but it is essential, so I wanted to discuss it further.
Direct rollover tax considerations
If you do a direct rollover to an IRA or 401(k), you don't have to worry about taxes now. If you had any after-tax contributions (like the VPA in GE's plan), you'll want to keep track of that amount.
Additionally, if you have after-tax contributions, you could withdraw those with no tax implications and roll the rest into an IRA.
Lump-sum withdrawal tax considerations
Regardless of whether or not you intend to do a 60-day rollover into an IRA or employee plan, a lump-sum withdrawal (except for after-tax contributions) will be taxed.
The following taxes will be withheld:
- 20% federal income tax
- State income tax (based on your current residence)
Additionally, if you are under 59 ½, you may incur a 10% penalty tax.
And if you intend to roll the money into another retirement account, you will need to have enough funds to cover the taxes that are withheld. You will receive a tax credit on your income taxes when you file them.
So back to our $75,000 lump-sum example, you'd likely have the following withheld/due:
- $15,000 in federal income tax
- $3,750 in state tax (this will vary according to your state – I used a 5% tax for demonstration)
- $7,500 early withdrawal penalty
That would leave you with about $48,750 after taxes.
If any of your contributions were after-tax, that number would be higher.
Over $25,000 in taxes and penalties…
However, keep in mind that other than the early withdrawal penalty and after-tax contributions, you'll be paying income taxes on any distribution you receive. Either now or in retirement.
Estimating the current value of your pension
If you aren't receiving a buyout offer and you have made it this far, thanks for sticking around!
But if you're in that situation and have a defined pension, you may be wondering what it might be worth if you were to receive a buyout offer. That amount is also known as the present value.
First, you need to calculate the pension value at the time you retire.
To get that you'll need the following:
- Annual distribution (D)
- For our example, that is $900 x 12 months = $10,800
- Number of years (t) the pension will pay based on life expectancy
- We'll use 20, assuming 85 as life expectancy and 65 as retirement age
- Pension fund rate of return (r)
- This varies, but we'll use 5% for our example
Retirement value (RV) = D x [ 1 – ( 1 + r ) ^ -t ] / r
RV = $10,800 x [ 1 – ( 1 + 0.05 ) ^ -20 ] / 0.05 = $134,592
Then calculate present value using the following equaiton using the number of years until retirement as t (65-45):
Present value (PV) = RV / [ ( 1 + r ) ^ t ]
PV = $140,486 / [ ( 1 + 0.045 ) ^ 5 ) = $50,726
The numbers are going to vary based on the assumptions for the interest rate and mortality that are used by the plan. However, $50,726 is close to the lump sum value of the defined benefit of our plan as discussed earlier.
An actual calculation by the company will likely use different interest rates based on different periods during retirement. But if you are just looking for an estimate, the method above should suffice.
Everyone's financial situation and goals are different.
Making the decision whether or not to accept a pension buyout is one that can affect the rest of your life.
So don't take it lightly.
I hope that this article has given you some insight on what to consider when facing this critical decision.
Do you have any other thoughts on what to think about when considering a pension buyout? Have you faced one before? What were your experiences?
Please share in the comments below!