When Do Lump Sum Pension Buyouts Make Sense?

Note: This article is part of Morningstar.com's 2020 special report, "Are You Able to Retire?" A version of this article originally published in April 2019.

Corporate pension-plan sponsors have been pursuing so-called "de-risking” for some time now--strategies that typically involve transferring defined-benefit pension obligations to insurance companies that replace them with annuities or offering lump-sum payouts to beneficiaries.

And that raises an important question: When does a pension buyout make sense for retirees?

Critics argue that it’s dangerous to mess with the income of people already in retirement, when there is less flexibility or time to make adjustments. Some also worry about presenting such a complex financial decision to older pension recipients who may have experienced cognitive decline affecting financial judgment. There also is worry about the potential for financial abuse by financial advisors or family members with an interest in accessing a lump sum.

The value of a lump-sum buyout is determined by the monthly pension amount you receive, your age, and actuarial factors determined by law and IRS regulations. The other key considerations are the current average mortality forecast for the U.S. population and current interest rates.

The value of buyout offers hasn't changed substantially over the past five years, according to Rick Jones, a senior partner at Aon. For example, a 70-year-old retiree with an annual benefit of $12,000 could have converted that to a $140,000 lump sum in 2015; this year, the conversion would be worth $139,000, Aon calculates.

But not all buyouts are equal from an economic value perspective. These offers are calculated using average life expectancy, blending together mortality rates for men and women. That means buyouts generally are less valuable for women than for men. Think of it as the flip side of the longevity coin for pension recipients, whereby a longer-lived female will receive more lifetime annuity-style pension income.

Beyond this, what are the upsides and downsides for a retiree considering a lump-sum offer? The Society of Actuaries created a useful guide considering these questions. Here's a quick rundown of the plus/minus from the actuaries list, but if you need to think about this issue more deeply, I recommend downloading and reading the analysis.

The key downside to consider is the loss of longevity risk protection. A pension provides a steady, guaranteed income source that you cannot outlive. And it even can be a source of income to pay for any long-term care expense down the road. Also, keep in mind that the decision to accept a lump sum is irrevocable--once you accept a lump sum, there is no way to return to the annuity stream later.

Another downside is exposure to market risk, depending on how--and when--you invest the lump sum.

“If you experience losses soon after investing the lump sum, your account value may not have enough time to recover from the loss before you die,” the report notes. “Or, the account value may take a very long time to recover. Either way, you risk running out of money before you die.”

On the plus side, the SOA notes, “a lump sum may enable you to leave behind an inheritance, assuming that you do not spend down the full lump sum amount during your retirement years.”

A lump sum also gives retirees the opportunity to customize income to fit their needs. A retiree in poor health, for example, might decide to take the lump sum either to meet current spending needs or based on a calculation that it is a better financial deal.

“At a basic level, it provides more options for retirees to better match income with their needs,” says Jones.

Getting Help With Decisions This is a complicated decision, and the information provided by plan sponsors to pension beneficiaries may not always be sufficient. A 2015 review of information provided by sponsors to participants conducted by the U.S. Government Accountability Office found consistent gaps in key information necessary to make informed decisions.

A key gap was failure to provide adequate information about the pension guarantees provided by the Pension Benefit Guaranty Corp., the federally sponsored insurance program that backstops private sector pensions. This is important because worry about the ability of sponsors to meet their obligations is a major driver of participant decisions to accept a lump sum. Two thirds of plan participants interviewed by GAO who had been presented with a lump sum cited default worries as a major factor driving their decision.

Pension funded ratios--a key measure of pension health--were fairly strong at the end of 2019, but they've taken a hit amid the pandemic, largely because of declining bond yields. Moreover, PBGC's financial health is mixed: While the single-employer insurance fund is in good shape, recording a surplus in 2018 for the first time since 2001, the multiemployer fund is hurtling toward insolvency, according to the Government Accountability Office.

Some plan sponsors make financial planners available to help pension recipients make sound decisions about lump-sum offers. If that isn’t available to you, it makes sense to get professional assistance from a planner when evaluating the offer.

Free assistance is available in some states from the U.S. Administration on Aging's Pension Counseling and Information Program. And the Pension Rights Center offers a guide to lump-sum decisions.

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to WealthManagement.com and the AARP magazine. He publishes a weekly newsletter on news and trends in the field at Retirement Revised. The views expressed in this column do not necessarily reflect the views of Morningstar.com.