A client was recently offered pension options by his former employer, a US energy multinational.
He had worked in the company for over a decade whilst contributing into the pension scheme. Currently 57, he would start receiving income in 8 years, when he is 65. The options were:
Keep in existing employer scheme until 65th birthday and receive an inflation-adjusted pension income starting at $33K p.a. gross.
Migrate the employer pension to an IRA (US Individual Retirement Account) with a transfer value of $390K.
Cash out completely with a 30% penalty (against the transfer value), receiving $273K today.
Keeping the calculations simple, I used www.mycalculators.com for the withdrawal schedule and impact of inflation. The withdrawal schedules are attached below for options 2 and 3.
Safe withdrawal rate = 4%
Inflation = 3%
Net annual return (equity-bond 50-50) = 3%
Pension income taken from 65 to 90
Option 1: Keep in existing scheme
For a long-serving employee of a multinational, 65 is a realistic retirement age and it’s reassuring to have a core source of stable income from the pension scheme of an international company.
To obtain this income stream as a private investor, one would require $825K of capital which would generate $33K in the first year, assuming a 4% withdrawal rate. At 3% inflation, his income at 70 would be $38,256 and at 80, $51,412, before the capital is fully depleted when the client turns 90.
Option 2: Migrate to IRA
An IRA would allow the client more control of his asset allocation. Assuming a 3% net growth rate over 8 years, the migrated $390K would grow to $494K.
Assuming a 4% withdrawal rate, the pension income in the first year (at 65) would be $19,760. With inflation at 3%, the income at 70 would be $22,240 and at 80, $29,889. The capital would be depleted by his 90th birthday in which the final income payment would be $40,168. These figures are well-below option 1 and with much less stability.
Option 3: Take the cash
If the client opted to take the cash and place it into an investment, let’s assume a net growth rate of 3% on $273K, holding for 8 years until his 65th birthday.
1.038 x 273K = $346K
Assuming a 4% withdrawal rate, income in the first year would be $13,840 hence we can see that there is no point comparing this to options 1 and 2.
The required growth rate to reach the IRA’s future projected value, as per option 2 (at 65th birthday), of $494K is an unrealistic 7.85% *
* This is even less likely with a 50-50 equity-bond portfolio and let’s consider that we are in the latter stages of a long bull cycle at the time of writing this article.
This would only be worth considering if the client had a specific business opportunity or the were desperate to place a deposit on his dream home. Even in such scenarios, this would only be recommendable if he had another sufficient and stable source of pension income.
We chose Option 1: To remain in the scheme and receive benefits at the likely retirement age. This is by far, the most secure option.
Given the above scenario, the company pension scheme may be underfunded in the long-term and they are trying to reduce the liabilities by incentivising early cash pay-outs and migrations – at the expense of the financial well-being of some of their employees. Just because some are engineers and PhD holders, it does not infer they are experienced in making financial planning decisions especially when the employer is encouraging Option 3.
Some employees may be tempted to take a cash pay-out to cover current needs or because they believe they can obtain a better return elsewhere. The decision to take the cash is irreversible and may result in financial hardship later in life when other income sources are unavailable.
When a large lump sum of cash is available and the company are trying to steer employees towards this decision, we encourage them to seek financial advice to and ensure they protect the long-term financial security of their family.