3M Employee? Major Considerations Before Taking Your Pension as a Lump Sum or Lifetime Income.
9 min read
Many 3M employees are offered the option to receive their pension as a lump sum or lifetime income. When researching which option is best, I've heard from clients that much of the blanket and cookie-cutter advice to be found online falls short. My goal with this writing is to briefly summarize the items you should consider as 3M employees in as succinct a way as possible. That said, many of the criteria that go into making such a big decision will create a snowball effect, each impacting the next. All should meet with their financial professional who knows their unique personal goals before making such a monumental decision, this is not intended as specific investment advice, but instead should serve as an educational tool providing context to criteria worthy of consideration.
Timeline
Let’s talk about how the pension benefits are calculated and why, if you are on the fence about whether to retire this year or next, it may be more prudent to retire sooner rather than later. Hence my desire to write this now, as there is a shot clock to capture a higher lump sum!
How is the pension calculated?
3M uses a formula incorporating your years of service, your salary, and a discount rate based on the prevailing interest rate environment.
If you log in to your benefits center and “project your pension income” vs. lump sum benefit, you must retire by a specific date to receive that quoted amount. When I reached out to the pension department, I was assured by the representative we spoke with that our quoted amounts would go down if we waited until the following year to stop working.
Why is this?
Well, to put it simply, it’s just math. The pension actuaries take a specific set of IRS-published interest rates (usually based on a corporate bond yield curve) that companies must use in their calculations. And, it’s no secret that the Federal Reserve has been steadily raising rates to combat inflation, which will invariably reduce the benefit next year. This is because you are discounting the value of a stream of future payments. For example, if the rate used for this year is 2.65% (Moody’s Seasoned Aaa bond yield on Dec-21), and the corresponding quoted pension income is $3,500/mo ($42,000/year). Also, let’s assume our employee is 62, and the pension calculation uses the average life expectancy of a 62 year old (23.8 years) or roughly 83 years of age. This would yield a lump sum of $718,266. If next year, when the benefits reset and the discount rate is surely higher (the same rate in May-22 was at 4.12%) then the lump sum amount would drop to $617,938. A reduction of about $100k, or almost -14%! Furthermore, let’s assume that rates rise by the same amount next year (about 55% again). This would decrease the benefit amount to about $500k, or around -30% of the benefit available for this year! The proof is in the pudding; timing and rates are everything when it comes to a lump sum- see the graphic below for greater clarity on these calculations.
So why is this so important now?
Each year, this lump sum offer resets. While the IRS updates the rates frequently throughout the year, many companies will grab a single month for that year’s calculations. To receive the amount currently quoted in your benefits portal, both 3M HR & the pension department recommended to us that we need to be coded in their system as retired and have received our benefit before December 1st; otherwise, we won’t receive the benefit until January 1st, and the benefit will be lower because the new rate used will be higher. We were also recommended to leave a minimum of 30 days to be coded in the system appropriately, which would mean our last day would need to be before October 31st, and we should put in our two weeks sometime around mid-October. Whew! I realize that’s a lot to remember; check out my nifty graphic below that reflects what was relayed from HR and the Pension Department.
Control & Choices
When evaluating whether to take the pension or lump sum, the first two things that should be considered as a starting point are survivorship & cost of living adjustments (or COLA if you want to impress your colleagues around the water cooler).
Survivorship is the amount your spouse would receive should you pre-decease them.
Here’s an example:
Survivorship 0%: $4,000/mo promised to you, and should you die first, your spouse receives $0/mo
Survivorship 50%: $3,750/mo promised to you, and should you die first, your spouse receives $1,875/mo
Survivorship 100%: $3,500/mo promised to you, and should you die first, your spouse receives $3,500/mo
These amounts differ because the Pension Fund is on the hook to guarantee not only your life but your spouse’s life as well. Promising to payout on both of your lives, increases the overall life expectancy (how’s the saying go? Two lives are better than one?), so it’s prudent to lower the overall amount promised.
For simplicities sake for our comparison (as with the lump sum option, your spouse would receive 100% of the account), let’s elect the 100% Survivorship option. *As with any of these decisions, they should all be evaluated individually, and this is not intended to be specific advice for your unique situation.
Cost of Living Adjustment (COLA) *told you that you’d sound cool using that term.
This metric essentially dictates how much, if at all, your pension income will increase from year to year. Some pensions offer an annual step-up based on a flat percentage; some offer a metric tied to the previous year’s inflation rate, but most don’t provide a COLA. Ideally, we would want some COLA, as the lack thereof means that your pension buys fewer and fewer things each year that passes.
Unless you’ve had your head in the clouds, you are well aware that inflation has thrown a wrench in the works this year. Your retirement (god willing) will span a few decades, so instead of using the current levels, let’s use long-term inflation metrics since 1960 of 3.8%. You can see in the graphic below how much of a deficit your pension is running by the 23rd year (remember average life expectancy is 23.8 years if you are 62). This would mean your $42,000/year would only be able to purchase $16,704 in real dollars. Effectively, enabling you to buy about -60% of the stuff you used to be able to! Not a problem when you first retire, but inflation is known as the silent killer; your retirement could be dead on arrival, only to become a noticeable issue years later. Indeed, death by a thousand papercuts. Unfortunately, according to 3M’s pension department, your plan does not offer a COLA. We want to verify this for you specifically, as there may or may not be differences in guarantees and pensions depending on when you started working for 3M, salary, etc.
Moreover, instead of saying your $42,000 in income would only be worth $16,704 23.8 years in the future, what if we looked at this from another perspective? So, on the flip side what would it take, in terms of income, to buy the same things it does down the line? Astonishingly, over a hundred grand a year when you are about 86 years old to buy the same stuff that $42k does today! Case in point - COLA certainly matters!
If you liked COLA, you are going to love Hurdle Rate.
Go ahead, throw it around next time in the break room. This is where the rubber meets the proverbial road when evaluating pension vs. lump sum (albeit in a vacuum and not considering many of the other unique variables we’ll cover below). The Hurdle Rate is the rate of return you would need to earn to distribute income as if you’d taken your pension. So, supposedly ask yourself, “If I had elected to take my lump sum and invest those dollars, what would I need to have my investment grow by, on average, to kick off the same amount of money as was promised for income?”
So in continuation of our hypothetical example, you can see in the calculation below, if your investments grow by at least 4.95% per year, our results are the same after 100 years. This is our magical “hurdle rate.” Whereby, we take our previously calculated lump sum amount of $718,266 and show that amount invested at 4.95% per year, taking the same $42,000 a year as income (effectively getting you the same income that the pension would have provided). The idea behind calculating things this way is to say, alright, if everything is like-for-like, what rate of return do I need to earn out to age 100? You’ll notice that at life expectancy (23.8 years later) you’d still have $452,872 in your account to leave to your spouse or children. In fact, if you planned to kick the bucket exactly 23.8 years later, you’d only need to earn 2.63% as your hurdle rate!
So how reasonable is it to assume an average annual growth of 2.63 - 4.95%?
“Alright, Ben, this sounds great and all, I get that its apples-to-apples, and I get the same income, but now I’m taking investment risk? Hit me with some stats that can help give me some confidence.”
Oh boy, historical data- my favorite.
This is one of my favorite charts from JPM. They look back all the way to 1950, so over 70 years of data, I’d say that’s a solid sample size. Check out this video I made breaking down all of the bad things that happened to the market historically.
In the green, you see a broad measurement of stock returns, blue is bond returns, and grey is just a cookie-cutter 50/50 mix of stocks and bonds. Notice how much of a swing there can be when just looking at a one-year period, compared to a 20-year period. Our 50/50 mix in the gray, all the way to right post’s +5% per year return as the WORST return over any 20-year rolling stretch in the last 70 years. That said, obviously, this can’t be guaranteed, nor would I ever pretend to, but this should still give us some confidence to invest, given all the bad things that have impacted markets over the last seven decades.
As with anything in life, all things carry risk. Taking the pension income carries a major lack of flexibility and colossal inflation risk to your purchasing power (another fun financial jargon term for you). In addition to the potential to earn more on your investment, I could make the case for taking the lump for a few more reasons.
1 – Hedge against inflation
2 – Flexibility to take more than $3,500. For example, maybe you’d like to budget for travel for the first ten years of retirement but spend less when you reach your 70s and 80s. This added flexibility in taking differing amounts of income from year to year should be considered.
3 – Beneficiaries – while your pension does offer a survivorship guarantee, it doesn’t account for both you and your spouse passing away. Say, god forbid; something happens to you in your 5th year of retirement. In our scenario above, your kids would still be able to inherit your lump sum (being held in an IRA) vs. $0 from your pension.
4 - Taxes (deserving of bigger letters as this here, is a big one).
Taking the income benefit is forcing income onto your tax return, potentially detrimentally and unnecessarily. For instance, if you have after-tax assets via cash, brokerage account, or Roth IRA, you may be able to supplement your income with these measures while allowing more room for other tax planning opportunities such as Roth conversions, letting your social security benefits increase, realizing long-term capital gains for potentially free, NUA tax strategy. This type of tax planning alone can make or break a retirement plan, with the opportunity costs potentially amounting to millions of dollars over your retirement.
5 - The resiliency of the company making promises or stability of guarantees. Litigation, insolvency, and business (stock) performance should all be evaluated when making one of the most significant decisions of your life. Fundamentally, how do you feel about the company making this promise? You wouldn’t be the first to have this concern, which is why most pensions are covered under the PBGC (pension benefit guarantee corporation), which insures against losses up to a certain amount. Truthfully you’ve spent most of your career working for 3M, I’d assume they’ve treated you right if you’ve stayed around long enough to be eligible for a pension. In no way am I throwing mud at them, just trying to sound off any and all things that are worth considering.
Long-term Plan.
So far, it’s been easy to evaluate these options separately, but when combined and personalized to your unique goals – how do things change? To say they shift a lot would be a more considerable understatement than the Detroit Lion’s perpetually broken secondary. Each retiree’s goals, risk tolerance, risk capacity (more on that here), asset allocation vs. asset location (more on that here), tax-loss harvesting (more on that here), health insurance selections, Roth IRA conversions, NUA Strategy (company stock in your 401(k)), when to take Social Security, and much more all can contribute or detract from the success of a plan and whether the lump sum or pension income would be the better option for you. However – we have some great technology available to us that can make reasonable assumptions and projections to assess your situation.
Two Ways to Combine and Plan Out All the Info
Average Return
This is the most basic way to run a retirement plan. Take the average return and project it out, netting out the optimal way to take income and expenses over the long run to the end of retirement (either average life expectancy or even out to age 100 if you want more peace of mind).
Results: When comparing pension or lump sum, the average return plan with the most left at the end typically is a way to ascertain which is best.
Monte Carlo
The highest probability of success, considering timing risk. This type of simulation is the same in terms of variables but gives your retirement a likelihood of success (i.e., in how many scenarios do you still have money left at the end).
Results: When comparing pension or lump sum, the Monte Carlo plan with the highest probability of success is generally the better way to go.
Bottom Line.
So, all this to say, evaluating which is best for your situation is challenging. I hope this provides some insight and can help aid in your decision process.
Ultimately, if you are on the fence about whether to retire before the end of the year, it would be prudent to run an analysis of your unique situation, as there could potentially be an advantage to retiring prior to the end of the year. Heck, even if you are a few years out, you should still be evaluating opportunities and making moves on a few things that may make sense before retirement while you still have working/earned income.
If you’d like a complimentary review and analysis of your options, please don’t hesitate to reach out. I’m based in Michigan, but I work with clients all over the country- you’ve got to love Zoom! You send me an email (here) or book a call directly on my calendar (here).
IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for
any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no
guarantee of future results. All indices are unmanaged and cannot be invested in directly.
Stock investing involves risk, including loss of principal.
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