Factors to consider before taking a pension buyout

Updated December 5, 2023 

Many companies providing retirement plans have started giving former employees the option to take a pension buyout in a bid to remove existing pension obligations from their balance sheets. However, deciding whether a lump-sum payout is better suited for your clients than a guaranteed monthly benefit requires careful assessment of several variables. 

In this article, Investment News takes a deeper look at the different factors that you, as a financial adviser, need to weigh when your clients are approached with such an offer.  

We will also discuss why employers offer pension buyouts and when accepting an offer makes sense financially.  

Share this guide with your clients to let them in on what goes on behind the scenes.  

What factors should you consider before taking a pension buyout? 

Determining whether your client will benefit the most from a pension buyout involves several layers, according to Matt Cosgriff, head of wealth management advisory services at SageView Advisory Group. 

“There will be a mathematical side, but there will also be more of a qualitative, big-picture side,” Cosgriff notes.  

Here are the most important factors that financial advisers need to consider when advising their client on accepting or rejecting a pension buyout.  

1. Buyout terms 

To ensure that you and your clients are making the right decision, you must first understand the terms of the buyout. Retirees often have several distribution options when receiving a pension. Here are the four most common payout methods:  

• Lump-sum payout: Many pension buyouts come in the form of a lump-sum distribution that represents the present value of your clients’ future pension payments. Retirees can opt for a lump-sum payout – which they can invest in a separate account – instead of a monthly income.  
• Single-life annuity: Also referred to as a straight life annuity, this provides the annuity holders with a monthly payment for the rest of their lives. The payments end at the time of their death.  
• Joint-and-survivor annuity: This payout option provides lifetime income payments to the annuity holder and their spouse. Depending on the pension plan, the surviving spouse may receive the full or partial payout amount.  
• Life income with period certain: This payout plan also offers lifetime income but guarantees payments for a certain period. If the holder dies during that period, the payments are distributed to the named beneficiaries until the period ends. 

2. Assumed life expectancy 

Mathematically, it may make more sense for a client with a high likelihood of living a long time to remain in the pension plan. 

Employers offer lump sums based on actuarial tables of average life expectancies, rather than individual life expectancies. This means someone who runs marathons, eats healthy and has family members with a history of living longer would probably outlive the average life expectancy. Therefore, they also earn more over their lifetimes with the monthly annuity payments than they would with the lump-sum distribution.  

By contrast, a client with low life expectancy would likely be better off taking the lump sum. 

“You have to make a guess in terms of longevity, in terms of how long those monthly payments are going to last,” notes Brad Arends, co-founder and CEO of the advisory firm Intellicents Inc. 

3. Risk tolerance 

Your client’s risk tolerance and your belief about future investment returns are also crucial factors when deciding if taking a pension buyout makes sense.  

Clients in their 40s with an aggressive risk tolerance, for example, may be more likely to invest a lump sum and generate more future income than they would get from their pension plans. 

“Risk tolerance comes into play in a huge way,” Arends says. “A good planner is going to come back with options. They’ll say, ‘Here’s a conservative way and a more aggressive way to look at it.’”

4. Client’s goals 

Another important consideration is the client’s goal for the assets. If your client is looking for income, then they would likely be better off rejecting the buyout offer and staying in the pension plan. Meanwhile, if they’re planning to leave a legacy for their children or grandchildren, they may benefit more from a lump-sum payout. 

5. Employer’s financial stability 

Financial advisers should weigh the financial stability of an employer and its pension plan. If the company defaults and its pension obligations are supported by the federal Pension Benefit Guaranty Corporation (PBGC), retirees may get only a portion of the benefits they’d previously been promised.  

If there’s concern about a company’s future solvency, then your client may be better off taking a lump-sum payout. 

6. Spending behavior 

There’s also a behavioral element that comes into play when deciding if a pension buyout is the best decision, according to Cosgriff. 

“If you have someone who’s incapable of living within a budget, maybe the annuity is better from a behavioral perspective,” he notes.  

7. Tax considerations 

Taking a lump-sum payout also affords tax flexibility that a pension plan wouldn’t. For example, clients who opt for an annuity payout get the chance to accelerate that income periodically to fill up marginal income tax brackets or do Roth conversions. 

Taxes, however, should largely be a secondary consideration. 

Why do companies offer pension buyouts? 

The increasing number of employers offering pension buyouts reflects a broader shift from traditional pensions to defined contribution plans such as 401(k), 403(b), and other employee-funded retirement savings plans.  

Doing so enables companies to remove pension obligations from their books. Back in 2019, General Electric (GE) offered lump-sum payments to 100,000 former employees. In addition, the industrial conglomerate froze the pension plans of 20,000 US employees. 

The move was aimed at shoring up its pension plans, which were $27 billion underfunded at the end of the previous year. GE later announced that the pension changes were expected to trim $8 billion from its pension deficit. 

Pension buyouts can also occur if a company needs to right its financial ship during challenging times. If this is the case, the company may not be able to continue funding your client’s monthly retirement benefits. Once this happens, it may be best for your client to accept a lump-sum payment. 

Lump-sum payout vs. monthly benefits – which is better? 

Because each client comes with their unique set of personal circumstances, there’s no one-size-fits-all answer to this question. However, many financial experts use the 6% rule as a general guide when evaluating whether a lump-sum payout or monthly retirement income suits their clients.  

Under the rule, if the monthly pension offer is 6% or more than the lump sum, it makes more sense for your clients to go with the guaranteed monthly income. But if the value is less than 6%, your clients would benefit more by getting the lump sum and making smart investments.  

You can use this formula to calculate the percentage: 

Here are some sample calculations: 

For a client choosing between a $1,000 monthly pension or a $160,000 pension buyout: 

Under this example, the monthly income is 7.5% more than the pension buyout offer, so the guaranteed pension is a better deal for your client.  

For a client choosing between a $708 monthly pension or a $170,000 pension buyout: 

Here, your client’s monthly pension is just around 5% of the lump sum. Considering this scenario, your client would benefit more from getting the pension buyout. 

Are pension buyouts taxable? 

The Internal Revenue Service (IRS) categorizes pension buyouts as ordinary income, meaning these are taxed at the highest income tax rates. The agency imposes a mandatory income tax withholding rate of 20% on most lump-sum payouts from employer pension plans.  

Apart from this, pension buyouts can push your client’s income into a higher tax bracket. These can likewise trigger additional investment taxes on other income sources, depending on the amount they receive. Lump-sum distributions can impact your client’s eligibility for other tax benefits and deductions as well.  

However, there are ways to avoid these taxes. One of the most common ways of doing so is to directly roll over the lump sum into an individual retirement account (IRA) or other eligible retirement savings plans. 

When should your client accept a pension buyout? 

The decision on whether your client should accept or reject a pension buyout offer depends on a range of personal and financial factors. Here’s a checklist to guide your client in making the right decision: 

You can keep abreast of the latest updates about pensions and retirement in our Retirement Planning News Section. Be sure to bookmark this page to easily access breaking news and the latest industry developments.