Wednesday, November 16, 2016

Early Out and Lump Sum Distributions

Why would a company offer you an "early out" and a lump sum instead of a pension?

A reader writes that their parents were offered an "early out" to retire and a "lump sum" in lieu of their pension.   Is this a good deal or not?    There are pros and cons of the lump sum.   The long and the short of it is, you may not have much of a choice in the matter, as if you push to remain on the job, you maybe pushed out.

But let's look at why companies do this and what the pros and cons are for you.

Companies often offer "early outs" to employees to cut down on head count and get rid of their most expensive employees.  Joe Blatz has been working at the finger-cutting factory since he was 21 and is now making $35 an hour or $70,000 a year.  With Social Security and Medicare taxes, not to mention benefits, he costs the company well over $100,000 a year to employ.  His health care costs are very high - and covered by the company's health plan, driving up their premium rates.

There are numerous reasons to want to get rid of Joe Blatz.   He is older and maybe not working as hard as he once did.   His skill set isn't up-to-date - he doesn't understand why we need these "newfangled computers" and whatnot.  The company may be downsizing and doesn't need as many employees.   Younger, healthier people can be hired for half as much salary - and far less in terms of benefits (which may no longer be offered to "new hires").

From management's point of view, there are a number of reasons to offer him an "early out" and a lump sum.   By reducing head count, Wall Street will drive up the stock price (and yes, stock analysts look at head count and revenue per employee in making stock price evaluations).   They can also cut overhead costs by hiring younger workers, or simply not replacing Joe at all.  They can take a long-term pension liability off their books which also makes the stock price look more attractive.   And since managers are paid in stock options, all of these reasons motivate them to offer a deal to Joe if he will leave.

Now, you may argue this is "unfair" and maybe you are right.  In the old days of the Unions, the "senior" employees were protected from layoffs and worked until they were 65 and then got fat pensions.  The older and older they got, the more they cost the company, as wages were based on seniority and benefits costs escalated as employees aged.   An older employee was a liability, not an asset, but the union rules protected them.   Today, we are in a new post-union era where blue-collar jobs are competing with overseas labor.

And in a nutshell, that is why the Democrats lost the union vote - which was a smaller part of the electorate anyway.   But if you think Trump is going to "bring back your job" and allow you to work until you are 65 and retire with a fat pension, think again.   If you doubt this, ask any of his casino workers how Trump feels about unionism.

(Note also, that in this era of Mitt Romney "Vulture Capitalism" that the company might be sold and stripped out, and the pension liability, underfunded, shuffled off to some shell company, with the whole thing collapsing and the "fat pension" being cut in half.   So maybe the union plan was bound to fail, anyway).

But I digress.

The other factor, of course, is that it may be possible to offer Joe Blatz a "pile of money" in a lump-sum payout and snooker him into taking an amount that would be far less than what he would collect in pension.

Using the 4% rule for retirement, if you wanted to collect $40,000 a year for 30 years (including adjustments for inflation) you would need a cool million dollars in the bank to generate that level of income.   If your pension was higher than that, well, you'd need a whole lot more.

Joe Blatz doesn't realize that.  The company could offer him $500,000 and he might bite on that, thinking it is a "lot of money" and enough to retire on.   But as we shall see, it might not be nearly enough.

But getting employees to take less than they would have gotten ordinarily is one reason they offer these early-outs, and it is a reason the retiree could be screwing themselves.

So what are the pros and cons of taking an early out?

Well as noted above, one "pro" might be you have no choice.   If you are a union member, maybe the union will protect you and you will not be forced into early retirement.   But if you are a salary worker (but not in upper management with stock options and golden parachutes) you might be "offered" an early-out and lump-sum payment as "inducement" to leave, with the unstated (or stated) understanding that if you don't take the deal, you may be forced out.

So for example, you are 55 years old and a decade away from what you thought would be your retirement age.  The company offers you a "pile" of cash to leave and hints strongly that if you don't take the deal, you will be let go anyway.   If you take the deal, you have some cash to spend to support yourself.  If you don't take the deal, you may be able to collect on your pension - ten years from now.

This is the conundrum may 50-somethings face these days and I have written about it before.  Many folks find themselves losing well-paying jobs when they reach that age and end up in "second careers" that pay far, far less.  Yes, this may be "unfair" but I doubt it will change anytime soon.

Another "pro" of the lump-sum is that it is an assured deal.   Companies go bankrupt and pensions are underfunded.   The Pension Benefit Guaranty Corporation may pay out 40 cents on the dollar on your pension, if your company goes bust, depending on how much debt the company had and how well-funded the pension was.

The problem with that scenario is that even "fully funded" pensions can be cut as Eastern Airlines pilots discovered.  Their pensions were lumped in with the flight attendants, ramp rats, and mechanics, and then divvied up and they ended up getting a lot less.

And then there is the Trucker pension plan that nearly bankrupted the PBGC.   And it still may.   So "guaranteed pensions" are anything but.  Even some government pensions from small municipalities may be at risk these days.   A bird in the hand is worth two in the bush, so maybe a lump-sum payout could be a better deal - sometimes.

Another positive aspect, at least for your children, is that a lump-sum payout is something you own.  You can leave it to your heirs, your new spouse, or whatever.   Pensions, on the other hand, usually terminate when you do, or when your spouse dies (whoever is last) with no survivors benefits.  If you remarry after you have started collecting your pension, you spouse may not be able to collect benefits after you die (if you think about this, it makes sense.  And 80-year-old marries a 22-year-old days before he dies.  Should the pension plan now pay her for the next 60-70 years?  Of course not).

And sometimes this is "unfair."  I know a couple who, because they got married only after her husband retired will not receive spousal survivor benefits.   For older couples, if you remarry after your spouse dies, you may lose your deceased spouse's benefits - making it more attractive to "live in sin" than to remarry.   Something to think about if you are having a romance in the retirement home.   Ditto for Social Security benefits - do the math before you make an impulsive "romantic" move!

A lump sum, on the other hand is in your bank account.  If you pass away, you can leave it to your spouse (new or old) or to your children.   So for the kids, taking the lump sum seems like a swell idea - provided you die early and leave it to them. 

On the con side, if you live too long you might end up a burden to those same kids, as their dreams of an inheritance evaporate and are replaced by your constant pleas for money.

And that is the real con right there.   Since you are retiring early you will need more money to live out the rest of your life, unless you get a new job or start a second career.  If you run out of money before you die, you will be in a difficult situation, to be sure.   And if you took too small a "lump sum" in lieu of pension, well, the problem is compounded.

The beauty of a pension is that, like a life annuity, it pays out a fixed amount, every month, until you die.   It is (supposedly) a guaranteed stream of income.   But like I said, these days, that "guarantee" is less and less solid.

Another con is that you could squander that lump sum either by spending it too quickly or by making poor investment choices.  Most salary slaves or hourly workers are not used to handling large sums of money.  Most of us are not sophisticated investors.   And many folks want to "double down" by investing their lump-sum payout in risky ventures, the worst of which would be to start your own business.

For others, it may be merely timing.  In 2008, most of us saw our investment portfolios drop by 50% in value.   If we hung on for a year or so, we made our money back - and then some.   But if you needed to withdraw that money during that down time, it was a costly withdrawal.

Spending is another problem.  When you get a paycheck or a pension, it is a lot easier to budget your life by spending only what you take in every month (of course, you can negate this by borrowing).   With a lump-sum, there is a temptation to spend more as you have "a lot of money" or if the market is going up, you may think you are making a lot of money and have plenty to spare.   But if spending is unchecked, well, it can end up draining your nest egg in no time.

Health insurance is another aspect.  In your late 50's and early 60's, health insurance costs can skyrocket to well over $10,000 a year or more, depending on your health history.  Obamacare promised to alleviate a lot of this stress, but now that Trump is President-elect, we may be going back to the "old days" where you paid as much in as you got out, making health insurance expensive and kind of useless. 

If your company offers to keep you on their health care plan, that is a real plus and something to consider.  If you have to pay for your own health insurance, consider the real costs, not only today, but in the future.   Also, even if the company promises to keep you on their plan, remember that if they go bust, you may have to fund your own health care.

There is a lot of risk with lump sums, to be sure!

So, should you take an early-out or not?    Like I said, you may not have a choice, as the company will "make you an offer you can't refuse" and if you don't take the early-out you may find yourself "out" in any event. 

But I would consider the following criteria before making a decision:

1.  What would the monthly benefit of my pension be?

2. What equivalent lump sum would generate the same amount as my monthly pension for my life expectancy?

3.  Is the amount in step 2 greater or less than the amount they are offering? (expect it to be less).

4.  Can I negotiate for more money?

5.  Have I factored in the additional length of my retirement due to my "early out"?

6.  Do I keep my health insurance or do I have to pay for my own?

7.  Do I have any realistic options for a new job or second career?

There are a lot of aspects to consider and I have only touched on a few here.  In my many years working for large companies, the government, and law firms, I have seen the "early outs" offered to (or forced upon) employees on many occasions.  Sadly, I have never been able to talk earnestly with my former co-workers as to how their early retirements or lump-sum payouts worked out.   Most folks don't like to talk about money or how much they have or how much they were offered.   And once people retire from a job, you lose track of them as they move away and whatnot.

However, I do know a couple of folks who took "early out" lump sum payouts and it didn't quite work out the way they thought it would, mostly because they spend too much, invested poorly, or squandered their money on ill-conceived business ventures.

* * *

NOTE:  The term "early out" as an offer for early retirement should not be confused with the frightening new technique of pre-collections that is being used on consumers by collection agencies and finance companies.