This paper is the first part of a two-part series. In the first part, we discuss the considerations involved in evaluating different pension options. As follow-up, the second part will discuss whether there is a benefit to including life insurance as part of the pension evaluation decision.
Single Life or Joint and Survivor Pension? It depends…
For those attorneys whose firms offer a pension, one of the most important decisions that need to be made as retirement approaches is what form of pension to take – a single life, joint and survivor pension, or lump sum payment. This memo is the first part of a two-part series discussing pension decisions frequently faced by attorneys.
In part two of the series, we will analyze how life insurance may be added into the mix as a possible way to maximize retirement income and overall wealth accumulation. But before answering the question of whether to choose a single-life or survivorship pension, this article conducts a brief primer on the terminology and the mechanics unique to this retirement benefit.
Introduction to Retirement Plans for Law Firm Partners
There are several types of “pensions” that law firms may provide to its partners. In the past, most pensions were unfunded plans (i.e., paid out of current firm earnings) where the firm contractually promised to pay retiring partners a certain amount per year. This amount was typically tied to the retiring partner’s compensation earned during the last several years leading up to retirement. Often, the ongoing annual pension payment was tied to the profitability of the firm, in addition to being capped in total as a percentage of firm profits (meaning pension payments could actually be reduced).
Over the years, as these pension amounts grew larger as a percentage of profits, firms found themselves with a very large liability. In order to shift the burden of these liabilities from the firm to the individual partners, many law firms have instituted other types of retirement plans where the firm contributes funds to qualified accounts such as a cash balance defined benefit plan or defined contribution accounts. However, several firms still have some or all of their retirement plans provided by unfunded pensions. In any case, whether it is a funded or unfunded pension plan, retiring partners typically have a choice as to how they would like to receive payments: over their life, over the joint life of themselves and their spouse or in some cases, a lump sum.
How are Pension Amounts Calculated?
As stated earlier, unfunded pensions are typically calculated based on some portion of earned income prior to retirement, often adjusted for firm profitability or the consumer price index (CPI). Funded Defined Benefit plans are regulated by IRS rules as to how much of a lifetime income benefit can be provided. Complex calculations are performed by actuaries to determine how much can be contributed to the defined benefit plan each year using a participant’s age, years until retirement, balance in the plan expected investment return, etc. The goal is to achieve a balance in the plan such that it would provide an annuity upon retirement that is limited (by IRS rules) to the lesser of 100% of the highest average compensation over 3 consecutive years or $225,000 (2019).
Single Life or Joint Life Pension Payments
Upon retirement the pension plan participant will need to make a choice regarding how payments are to be received; over the participant’s single life or some form of survivorship payment where, if the participant predeceases their spouse/partner, some amount of the pension will continue for the survivor until their death.
Typically, these survivorship options range from a 50% payment to a 100% payment, meaning, for example, the survivor will continue to receive 50% of the payment paid during the participant’s life. In order to calculate different payment amounts depending on which payment plan an individual chooses, actuaries use mortality tables to determine life expectancy. Upon reviewing these tables, certain facts are apparent:
- Women live longer than men
- As you age, your total life expectancy increases
- The combined life expectancy of two people is longer than the life expectancy of any single life
- The larger the difference in age between two individuals, the longer the life expectancy of their joint lives.
So, which payment schedule is the correct one to choose? The opportunistic answer for an advisor like this author is, “it depends.” Unfortunately for the reader, there is no quick and easy, “Google it” answer. To help answer the question, it is essential to understand all the factors to consider. Below is an example based loosely on a real-life example.
Single Life vs. Joint and Survivor Pension Example: The Smith Family
Mr. Smith was a very successful partner at a large law firm. Although he earned significant compensation during his life, he did not save as much as he had originally planned. He and his wife had a nice apartment in Manhattan with a small mortgage and, in addition, had a lovely home in the country on a large piece of property. The country property was their pride and joy, but the taxes and maintenance were significant, thus diminishing their ability to save.
Mr. Smith retired at age 60 (Mrs. Smith was also age 60) and his firm provided a generous pension offering the ability to take the pension over his life (single life pension) or a form of joint and survivor pension, where if Mrs. Smith survived Mr. Smith she could receive a portion, or all, of his pension. Mr. Smith elected to take the single life pension given the significant difference in the payment between a single life and joint and survivorship pension, his need for significant current cash flow (the county home), his family longevity,and excellent health at retirement.
So, did he make the right choice? Before drawing any conclusions, we need to look at the different pension amounts offered. The single life pension was $425,000 per year. If he chose the 100% joint and survivor pension (i.e., the payment would remain the same for Mrs. Smith if the Mr. Smith passed away first) the payment was reduced to $346,000 per year – a decrease of $79,000 (or 18.5%) per year. If he chose a 50% joint and survivor pension the annual payment would be $381,000 (and therefore $190,500 for Mrs. Smith) – a decrease of $44,000 (or 10.4%) per year. These different pension amounts and options present a complicated scenario for the Smith family.
Should Mr. Smith Choose a Single Life or Joint and Survivor Pension
From a purely mathematical perspective, the variable “T” (time)with the most weight in determining the “right answer” is a question to which nobody has the answer – when will each of you and your spouse die? If we knew that answer, we could calculate the optimal decision that would maximize the pension amounts paid to the family. To illustrate how these different pension schemes work, it is essential to do some math with several defined assumptions outlined below.
In this oversimplified example, we will be using single life expectancies according to the latest Vital Statistics Table. Realize that there are more complex calculations using different tables that actuaries use, but we will be looking to illustrate conclusions that are likely not materially different from those using more exact tables. According to this table, the average life expectancy for males and females in the US is approximately 76 years and 81 years, respectively.
In addition, for purposes of this example, results are reported on a present value basis. In other words, we will discount payment streams made in the future into what they are worth today. In financial modeling, this is how you make an “apples-to-apples” comparison. In this example, we will also need to make an assumption. We will use the 10-year Treasury bond rate of 2.25% to discount our numbers (obviously this rate is very low from a historic perspective and changes in this rate will have an impact on the results). Now, math.
If we calculate the present value of the 3 different pension options we described above, we find that if Mr. and Mrs. Smith die at the ages the tables expect (76 and 81), the results on a present value basis are essentially the same – approximately $5.95 million. This makes sense since the firm doesn’t want to make it more financially advantageous for an employee (and therefore less financially advantageous for the firm) to select one form of pension over another.
What happens if you don’t die at your actuarial life expectancy?
To illustrate, let’s see what happens if Mr. Smith lives 3 more or 3 fewer years different from his life expectancy. See the table below for the results.
As demonstrated by the table above, selecting a single life pension yields the greatest difference in result – if you live longer you win, if you don’t you lose. In the 100% survivorship pension the results are the same in all cases. This is because in our example the change in Mr. Smith’s life expectancy is less than the difference in the life expectancy between men and women (5 years according to the Vital Statistics Table), that is, we use Mrs. Smith’s life expectancy to age 81 to determine all three amounts. And finally, the 50% survivorship pension results in an outcome somewhere in between.
As one may suspect, there are a multitude of iterations that can be performed on this analysis, each with slightly different results. For example, the results would be very different if spouses are significantly different in age. In addition, relative health factors should be considered—perhaps one spouse has a serious illness that would shorten life expectancy.
What about taking a lump sum payment rather than an annuity?
Law firm partners may be presented with an option to take a lump sum immediatelyrather than having a pension pay out over their life expectancy. Taking a lump sum distribution versus an annuity comes down to a few factors, the most important of which is the discount rate used in determining the lump sum amount. It is important to know what that is, because the discount rate becomes the “hurdle” investment return that must be met or exceeded in order to match or exceed the financial value of taking an annuity.
To illustrate a lump sum pension payout, the example above used a 2.25% discount rate to determine the present value (i.e., the lump sum equivalent) of the annuity. Therefore, in order to be financially better off, it would be necessary to exceed a 2.25% investment rate of return. The higher the discount rate, the smaller the present value of the annuity. If the discount rate in the example was 5%, the present value lump sum would decrease by over $1 million. In addition, life expectancy can factor into this analysis as well. If the employee (and/or their spouse in the case of a survivorship pension) exceeded life expectancy, the results may favor taking the annuity.
What are some other factors for couples to consider with pension payouts?
Other things to consider when making the pension decision include a realization that if a pension is unfunded it is nothing more than a promise to pay. Unlike funded pensions where monies are segregated and held in a separate account, as the recipient of an unfunded pension one needs to consider the long-term financial health of the firm. Although bankruptcies are a very rare occurrence for large successful businesses (especially for large law firms), they do happen from time to time.
One final point to consider is life expectancy. There is evidence which demonstrates that affluent people tend to outlive average life expectancies because of factors such as better diet, access to better health care and so on. Similarly, relative health at retirement should also factor into the decision. If these factors are in an individual’s favor, there may be greater wealth accumulation by taking an annuity.
Stay tuned: Integrating Life Insurance into the Pension Decision
The purpose of this paper is to raise awareness of some of the issues a retiring partner must consider when the time comes to choose a pension option. As stated at the outset of this paper, there is no clear-cut answer and at the end of the day, “it depends” is the real answer. To make the most informed choice it is helpful to have your financial advisor prepare the analysis and “do the math.” Actively serving the law firm partner market, Round Table Wealth Management is experienced guiding families through this and many other important financial decisions.
In the next series we will consider whether it may make sense to select one pension scheme, typically the single life pension, in combination with purchasing a life insurance policy to replace the pension benefit in the event of a premature death or provide additional funds post-death. Obviously, that analysis requires many differing factors including not only life expectancy, but how long to insure, how much to insure, health status when purchasing the policy and so on.
So, was Mr. Smith’s choice of the single life pension the correct answer? Unfortunately, he did not live to his actuarial life expectancy. But that is not the end of the story. More to come