Should I Go for a Pension Purchase Option or Invest the Money? – A Reader Question

A few weeks ago I receive a really great question from a friend of mine (we’ll call him LJ) regarding whether or not he should take a pension purchase option that his employer is offering him.  Here’s the email he sent me:

I’m thinking about buying 5 years of generic pension service time. Seems like a no brainer, right? Not quite. I’ve had the actuarial done and it will cost me $37,800. A good chunk. I have the money in a 457 account and can roll it over to my pension administrator. I plan to retire in 22 years at 60 when I am eligible to draw the pension. I have 13.5 years of service currently. This would make it 18.5 years.

The reason that I’m considering this is that my pension multiplier is going to be reduced on Jan 1st from 2 to 1.5. Everything that I’ve earned to this point will be based on a 2 multiplier. Going forward, the pension will be based on 1.5 multiplier. If I buy the 5 years by Dec 31, they would be calculated using the 2 multiplier. That’s why I’m considering it.

The difference in the pension would be about $6,000 per year. 13.5 years is $16,000. 18.5 years is $22,000. This will be in addition to my pension years (22) going forward at the 1.5 multiplier. My fear is that I’m losing out on the compounding of the $37,800 for the next 22 years. At the historic return of 8%, that $37,800 would be worth around $200,000+ without ever adding a dime to it. What are your thoughts on this?

Interesting scenario, LJ …

Whether or not you expect you receive a pension from your employer (as of 2012 less than one quarter of US citizens still get a pension), don’t roll your eyes just yet.  This type of situation could still apply to your financial situation.  How?

Ever heard of an annuity?

Annuities have been around since the time of ancient Romans and probably will always be.  Even though they often get a lot of flack in the media for being complicated, there are still a good number of them that are perfectly legitimate financial products.  In fact if market fluctuations and risk scare you to death as an investor, an annuity could actually be a very good supplement to your overall retirement plan.

Similar to the pension scenario above, with most annuities you’re basically trading your money now for some defined benefit later on in life.

So whether it’s a pension you’re being offered, an annuity, or some other type of financial produce, every situation boils down to this simple fork in the road:

• How much money will I get if I purchase the product (in this case the additional pension service)?
• How much money will I have if I don’t purchase the product and just simply invest the money on my own?

Let’s do a deep dive into this and see which one gives us more.

Investing vs a Pension Purchase Option:

How Much More Am I Gaining with the Extra Pension Credit?

First things first, let’s say we spend the $37,800 and buy the pension service credit.  How much greater does this make our pension payments when we finally retire?

Unfortunately this is not always an easy thing to calculate on your own.  Usually it involves going to your HR department or pension plan’s website, plugging in some numbers, and seeing how much more money the plan will give you.  (That’s exactly what I have to do when I want to calculate how much my wife’s pension will be).

Thankfully LJ already did all the heavy lifting for us and found the answer.  At age 60 with the extra pension service credit, he will stand to make approximately $6,000 more each year.

What If We Just Invest the Money Ourselves?

So now what happens if we just keep that whole $37,800 right where it is and let it grow for the next 22 years?

Let’s take the entire $37,800 balance and assume we invest it all in an S&P500 stock market index mutual fund.  That way we’ll be following the simplistic investment advice of famous icons like Jon Bogle and Warren Buffett and capturing the average return of the market.  Looking back at market history this should produce an average annualized rate of return of approximately 8% per year.

If we wait 22 years until LJ is 60 years old, what will the value of our $37,800 be by then?

Using Excel:

Wow!  $205,501 is a lot of money!

But wait…  How can we compare this large sum of money in way that makes sense to the $6,000 per year we expect to receive from the additional pension credit?

My solution – Use the Safe Withdrawal Rate:

According to the safe withdrawal rate rule of thumb, a person should be able to withdraw 4% from their life savings every year for approximately 30 years with virtually no risk of running out of money.

If we use this simple rule of thumb, that means we should be able to pull $205,501 x 0.04 = $8,220 per year.

So who is the winner in this situation?  Obviously since $8,220 is larger than $6,000, investing the money works out to being a better strategy than purchasing the pension credit.

Note that the 4% rule works both ways.

Suppose you wanted to estimate the full value of that extra pension service credit.  To do so you could just go:

$6,000 / 0.04 = $150,000

Again, the $205,501 is obviously worth a lot more than the $150,000.

Here is a quick summary:

But Your Tolerance for Risk Could Change This:

There is one big caveat to this whole story problem.  Depending on your opinions of the market and risk, you could still argue in favor of the pension.

How Do You Define Guaranteed?

One of the biggest arguments in favor of a pension over other types of retirement accounts is that  a pension is guaranteed money.  The stock market is not.  In our assumptions, we’re simply playing the market averages and making reasonable assumptions that our money will continue down these same types of trends.  If you had decided to retire back in 2008-09 when the market was at one of its lowest points in the past decade, I’m sure that pension would be looking pretty good right about now!

Of course you could also argue that a pension is never really guaranteed either.  The Internet is awash with pension horror stories where people who paid their money for years didn’t actually receive the full amount they were promised.  Has anyone been following the drama of the pension slashing following the Detroit bankruptcy?

How Do You Define a Risk-Free Return?

Another way the pension could have easily been viewed as the winner is in defining what you call “a risk-free rate of return”.  In our assumption above, I decided to use 4% since that is the commonly used safe withdrawal rate.

But what if you can’t stomach that much risk?  Conservative investors will argue that the “true” risk-free rate of return is whatever the government treasury 30-year yield is (currently around 3%).   In that case you could calculate $6,000 / 0.03 = $200,000.

This figure is very close to the $205K figure we estimated if we were to invest the money.  But again this number is guaranteed whereas the investment figure is not.

What About Death Benefits?

Another thing that could have swung this debate one way or the other would have been whether or not there were any advantages with death benefits.

Thankfully LJ can rest easy – both options actually allow you to keep the money.  If LJ and his wife had invested the money and LJ were to pass away, that wouldn’t change anything for Mrs LJ.  She would become the primary owner of the investments and would continue to be able to pull money from it until it’s exhausted.

Bonus Strategy! – Lowering Your Taxes:

Here’s another cool twist to add to the whole investment vs pension debate.

Even though LJ will be keeping the money in his 457 account, what if it had been a regular-old brokerage account?  Even though there’s nothing wrong with parking your money in a brokerage account, you know you can do better tax-wise, right?

If you have the opportunity, why not invest the money in a Roth IRA?  (Learn everything you need to know about a Roth IRA here).

That way you not only end up with more money due to compound interest, but you also pay NO TAXES once you finally do withdraw the money.  Paying no taxes is way better than paying taxes on the pension you’re going to receive.

If all of this sounds complicated, it might help to talk to a professional about exactly what your options are.  That’s one of the cool perks about having a free account with Personal Capital.  After you sign up and start tracking your money, if it meets a certain minimum threshold you’ll be contacted by an adviser who will help you figure out what your next steps should be and you can both come up with a good strategy going forward.  That’s not bad for a free service!

Readers – How many of you have been faced with a similar type of proposition?  Did you decide to take the pension purchase option and if so why?

Images courtesy of Flickr | opensource.com