A former employee of Chrysler-Benz is vested in the company’s pension plan. The

Question

A former employee of Chrysler-Benz is vested in the company’s pension plan. The pension benefit would pay him $220/month for the remainder of his life starting next month. The company is offering a $55,000 buyout option, which means the employee would receive $55,000 today and forego the $215/month pension payments for life. In evaluating the buyout option, the employee (age 55) assumes he will live to age 85; and that the market rate of the return is 3.5%. Justify whether or not he should take the buyout in lieu of the monthly pension payments?

Explanation / Answer

A former employee ages 55 yrs. If you take monthly pension plan, you will receive $220 monthly for rest of your life. But this amount will not give inflation protection. Considering inflation, the benefit of monthly income will reduce tremendously in long term. If you take lump sum amount now then you are liable to pay takes if you don’t invest in employer qualified plans. This will reduce your lump sum amount by more than 10% - 20% or even higher in tax bracket. As you are retiring before 59, extra 10% early withdrawal penalty will be levied. This will reduce your lump sum amount upto 20% i.e. $44,000 (55,000 – 20%).

You can invest your lump sum amount investment type like annuity which generates monthly income. But market rates are given as 3.5% which will generate less than $130 monthly. Further, we have not considered the time value of money which will reduce the purchasing power in future for same $130.

You will get $220 monthly if you consider monthly pension plan instead of lump sum amount. Considering lump sum amount, monthly income will be generated is $130 which is as appx 60% if you take monthly pension plan. No information is given about his previous investments, savings etc. hence we will not consider these factors. As person ages, his healthcare exps comparatively increase. If you invest somewhere else, then such investments are subject to fluctuation which may impact your earnings negatively & reduce your monthly return.

So it’s always better to take monthly pension plan. This will fulfill your requirement of monthly exps. Investment made via lump sum amount is little risky at this age of life and should be avoided. Lump sum amount option should only be considered when such investments generate at least $200 so that your monthly exps meet and you have other investment made previously which is also generating stable income as well.

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