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Bruce A. Hyde
December 2, 2022
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 for law firm partners. For those attorneys whose firms offer a pension, one of the most important decisions that needs to be made as retirement approaches is what form of pension to take—a single life pension, joint and survivor pension, or lump sum payment. Which is the best choice?
In part two of the series, we discuss whether there is a benefit to including life insurance as part of the pension evaluation decision as well as 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, survivorship pension or lump sum, this article includes a brief primer on the terminology and the mechanics unique to this retirement benefit.
There are several types of pensions that law firms often provide to their partners. In the past, most pensions were unfunded plans (i.e., paid out of current firm earnings) in which 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 be reduced depending on profitability).
Over the years, as these pension amounts grew larger as a percentage of profits, firms found themselves with a very large liability. To shift the burden of these liabilities from the firm to the individual partners, many law firms have instituted other types of retirement plans in which 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.
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 three consecutive years or $265,000 (2023).
Upon retirement the pension plan participant will need to make a choice regarding how payments are to be received: over the participant’s single lifetime or some form of survivorship payment in which, if the participant predeceases their spouse, 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 amount 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:
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 that must be considered in the decision. Below is an example based loosely on a real-life couple.
Single Life vs. Joint and Survivor Pension Scenario: The Smith Family
John 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 Joan 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 costs were significant, thus diminishing their ability to save.
John retired at age 60 (Joan was also age 60) and his firm provided a generous pension, offering John the ability to take the pension over his life (single life pension) or through a joint and survivor pension, where if Joan survived John, she could receive a portion, or all, of his pension. John elected to take the single life pension given the significant difference in the payment between a single life and a joint and survivorship pension, his need for significant current cash flow (the county home), his family longevity, and his 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 Joan if John 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 Joan)—a decrease of $44,000 (or 10.4%) per year. These different pension amounts and options presented a complicated scenario for the Smith family.
Should John 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 are using single life expectancies according to a recent Vital Statistics table. Know that there are more complex calculations using different tables that actuaries use, but we aim to illustrate conclusions that are likely not materially different from those using more exact tables. According to the recent table, the average life expectancy for males and females in the United States 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 scenario, we also need to make an assumption. We will use a 10-year U.S. 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).
If we calculate the present value of the three different pension options we describe above, we find that if John and Joan 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.
To illustrate, let’s see what happens if John lives three more or three fewer years 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 John’s life expectancy is less than the difference in the life expectancy between men and women (five years according to the Vital Statistics table); that is, we use Joan’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.
Law firm partners may be presented with an option to take a lump sum immediately upon retirement rather 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, 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.
Other things to consider when making the pension decision include the 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 that 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.
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 “do the math.” Actively serving the law firm partner market, Cerity Partners has experience guiding families through this and many other important financial decisions.
In the next part, we will consider whether it may make sense to select one pension scheme over the lump sum, typically the single life pension, in combination with purchasing a life insurance policy to either 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 also how long to insure, how much to insure, health status when purchasing the policy and so on.
So, was John 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.
Cerity Partners LLC (“Cerity Partners”) is an SEC-registered investment adviser with offices in throughout the United States. Registration of an Investment Advisor does not imply any level of skill or training. The foregoing is limited to general information about Cerity Partners’ services, which may not be suitable for everyone. You should not construe the information contained herein as personalized investment, insurance, tax, or legal advice. There is no guarantee that the views and opinions expressed in this presentation will come to pass. Before making any decision or taking any action that may affect your finances or your company’s finances, you should consult a qualified professional adviser. The information presented is subject to change without notice and is deemed reliable but is not guaranteed. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
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Bruce A. Hyde is a Partner in the New Jersey office and has over 30 years of experience in the financial services industry. For the...
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