Earlier this month, General Electric announced a freeze on pension benefits for existing employees and a lump sum pension buyout offer for 100k former employees.
This topic is very real for me, both as a financial planner and as a former employee that has been promised a lifetime annuity starting at age 60. I worked at General Electric for approximately 17 years and joined the company well before they closed the plan to new entrants in 2012. So, why did they stop enrolling employees and why are they now freezing the plan for current employees and trying to buyout former employees?
A Brief History of Pension Plans in the United States
In 1875, the American Express Company established the first pension fund for employees in the United States. Broader adoption of this retirement funding strategy did not happen overnight. By 1940, about 15% of all private sector workers were covered by pension plans. At the height of its popularity, approximately 35.9 million workers, or 46% of all private sector workers were covered by a pension in 1980. Today, that number has fallen to 18% of domestic workers in the private sector, according to the Bureau of Labor Statistics.
What caused the decline in popularity of pension plans?
In 1978, the U.S. Congress passed the Revenue Act of 1978, which established that employees did not have to pay taxes on income they elected to receive as deferred compensation. A few years later, Ted Benna, a benefits consultant with a private company, used his own interpretation of this law to establish the first 401(k) plan that enabled employees who deposited money into their own accounts to receive matching contributions from their employer.
Aside from the introduction of the 401k and other alternative retirement plans, the other primary cause of decline for pension plans is their ever increasing costs. In 1960, life expectancy was approximately 70 years of age (67 for men, 73 for women). By 2010, life expectancy had increased to approximately 79 (76 for men, 81 for women). Any plan administrator had to take into account the statistical expectation of an additional 9 years of benefits. And we can certainly expect that the 2020 data will show another tangible increase in life expectancy relative to the 2010 figure.
Signing up for a guaranteed payment over a 20-30 year retirement horizon has made defined benefit plans financially unviable for companies. In order to address this ballooning liability on their balance sheets, they are required to explore all of their options. Two primary options that are available: (1) terminate or freeze their program so that additional benefits stop accruing and (2) offer discounted lump sum buyouts on benefits that have already been earned. As noted in the intro, GE pulled both of these levers by freezing their pension (effective January 2021) and offering lump sum buyout offers to former employees.
A Pension Buyout Example
A pension buyout offer is not readily available for most employees and thus it is a scenario that many have never even contemplated. Below are fictitious numbers, but they are presented in relative proportion to how the pension buyout offer from GE was presented to me in my offer letter.
Option A: Take a one-time lump sum in the amount of $150,000. By accepting this payment, you relieve the company of all future pension payment obligations.
Option B: Take a reduced monthly benefit of $725, which begins immediately upon your acceptance of this offer. Same as above, accepting this offer permanently reduces your lifetime annuity benefit to this agreed amount.
Option C: Take your monthly original monthly benefit of $2,275, which will begin the first month following your 60th birthday. This is the default option if no action is taken before the stated deadline.
OK, how should you go about evaluating this offer? Let's start with the lump sum (Option A) against the originally promised lifetime annuity (Option C).
The $150,000 lump sum equates to 5.5 years of the original annuity ($2,275 x 12 = $27,270 ; $150k / 27k = ~5.5).
Based on the simple "back of the envelope" calculation, you might conclude that getting 5.5 years' worth of benefits in exchange for forfeiting a lifetime annuity that could span 30+ years would be too much of a discount to be worth considering. But this is where the time value of money comes into the picture.
The $150k lump sum would be paid out today (or very shortly after accepting the offer). In my case, I am 16 years away from the first monthly pension payment. So, let's take the $150k and assume a modest average annual return of 5%. 16 years down the road, the $150k payment would grow to ~$327k. At the theoretical start line of retirement benefits, the lump sum balance is 12 times the annual pension benefit. If you increase your expected investment return to 6%, the balance at age 60 jumps to $381k (14x annual pension benefit).
It's important to note that the 5-6% annual return is not guaranteed and investing in stocks/bonds/real estate and other asset classes involves the risk of principal loss. That said, the long-term average annual return on the stock market (as measured by the S&P 500 index) is approximately 10% while the Barclays Aggregate Bond Index shows a long-term return of 3.18% (per Morningstar).
In my view, having close to 15 years of cumulative pension benefits in your account on the day your normal pension benefits would begin is a very compelling argument in favor of the lump sum. At age 60, you can begin to "pay yourself" the equivalent annuity while allowing the large remaining balance to continue to grow. You also no longer have the risk that your former employer will not make good on their promise of benefits throughout your retirement period. That said, there are several important questions to ask yourself before accepting that large buyout check:
Risks of Accepting the Lump Sum
1) Do I have the financial discipline to resist taking the lump sum and spending the money on something other than it's original purpose...my financial security in retirement?
It's not every day that someone places $150k in front of you. There could be many alternative uses: a down payment on a home, upgrading your car, contributing to your child's college fund. These might be noble causes, but in addition to robbing your own future financial security, you're also making a poor financial decision by subjecting yourself to current taxation AND by incurring a 10% penalty (generally before age 59.5). Rolling over the funds to a suitable retirement account (your current 401k or an IRA) will be the better choice unless you are currently facing major financial hardship or have debt at very high interest rates.
2) Am I confident that I can manage these funds on my own?
With great privilege comes great responsibility.....I think those words of wisdom come from Mr Spiderman himself. Receiving a windfall can be a blessing if you feel comfortable managing your money and choosing an appropriate investment strategy. For those that don't fall in that category, it can be a curse or a tremendous source of anxiety. Simply depositing the funds in the bank will earn you 0.01% in basic checking/savings or at best 0.8-1.0% (as of September 2020) if you choose a high-yield savings account. If you keep your money "on the sidelines" for 20-30 years, inflation will erode the purchasing power to about half of what it can buy you today. You need to have a well thought out plan to manage this balance or you need to find a professional to take on this responsibility for you.
3) Does my family show signs of longevity?
If you have several family member that have lived well into their 90's and you are generally in very good health, you might be well advised to at least pause and consider the potential that you also will live to a ripe old age. You need to have a financial plan that will fund a lengthy retirement period. One of the arguments in favor of keeping the pension is you cannot outlive it. Taking the lump sum increases the potential risk that you will outlive your money. On the flip side, if you have specific health risks or reasons to expect a shorter life expectancy, all else equal the lump sum payout becomes more attractive.
Risks of Holding On To Your Current Pension Benefits
Now that you have considered important questions on the risks and rewards of taking a lump sum payout, what risks need to be considered if you choose to keep your regular pension benefit?
1) What is the risk that my company will not pay my full pension benefit when I retire?
If someone asked me this question on the day I joined GE and started accruing my pension, I would have said there was practically a 0% likelihood that my benefit wouldn't be paid in full. GE was one of the largest public companies in the world and was the sole surviving member from the original Dow Jones Industrial Index from 1896! During the second year of my employment in 2000, the company reached its highest market cap (share price x shares outstanding) at $594 billion. As I write this, GE's market cap is $55 billion (a 91% drop), the once certain dividend has been cut to as low as $0.01, and the company has the largest pension deficit (assets minus projected liabilities) of any U.S. public company. Based on this fact pattern, I encourage anyone with a pension to run a retirement scenario where your employer cannot make the payments, the Pension Benefit Guaranty Corporation steps in, and your pension benefit is significantly reduced relative to its original value.
2) What happens to my pension if my former employer goes out of business?
As I eluded to immediately above, if your employer is no longer in business or can demonstrate a stressed financial situation, the Pension Benefit Guaranty Corporation (PBGC) is the government entity that will take over the pension liability and make payments to the pension participants. The PBGC is primarily funded by premiums collected from defined-benefit plan sponsors. Click HERE for some FAQ's on how the PBGC operates and the likely impacts to the timing and amount of your benefit payments if they were required to step in. In my view, while it is certainly good that the government has established the PBGC to protect pension participants, I'm not excited about a retirement funding plan that is relying on the federal government for both my pension AND my social security benefits. Also, if the PBGC is funded via premium payments from plan sponsors, the premiums are built on assumptions regarding how many pension plans they will have to eventually assume responsibility for. If the premium calculations underestimate their ultimate liability, it seems the PBGC might face the same fiscal challenges projected for the Social Security trust (i.e. benefit expenses are too high and revenue is too low).
Building a retirement plan involves several key assumptions (investment returns, life expectancy, tax rates, inflation, social security, etc) and has a lot of moving pieces. Hiring a financial planner can get answers to important questions like "am I on track to retire and stay comfortably retired?" and they can run retirement projections under both scenarios (1 - take the lump sum and invest it ; 2 - keep your monthly pension benefit) to see which projects a higher probability of success.
If you have been presented with a pension buyout offer and you are unsure of the best decision for your situation or if you would like an independent view on your progress toward retirement in general, please contact me or click HERE to book a complimentary consultation.