BUSI 688 Week 4 DB Forum 3 Example

Discussion Board Forum 3: Thread and Replies

BUSI 688 Retirement Planning, Discussion Board Forum 3 (thread and two replies)

Thread by [Student Name]

The forum topic, the retiree, the plan's offer and the classmates are composites standing in for the course's own; the calculations are illustrative, and the textbook and research cited are real; the requirements follow Liberty's public course guide for BUSI 688.

Thread

The topic presents a composite machinist retiring at 63 from a manufacturer's defined benefit plan. His wife is 60. The plan offers three choices: a single-life pension of $2,900 a month, a 100 percent joint-and-survivor pension of $2,550 a month that continues to his wife if he dies first, or a lump sum of $480,000. Dalton and Dalton (2018) explain that married participants receive a joint-and-survivor form unless the spouse consents in writing to another option, precisely because a single-life pension leaves the survivor with nothing.

Converted to annual income, the options look like this:

The pension pays far more income than a cautious withdrawal from the lump sum. To match the $30,600 joint pension, the couple would have to withdraw more than 6 percent a year from $480,000, a rate that risks running out of money if either lives into their nineties. The lump sum would also put the investment decisions in their hands for the first time in their lives, at the same moment they lose a paycheck. A planner should ask whether they have the temperament to hold through a market decline without selling, because a large loss in the first years of withdrawals does damage that later gains rarely repair.

Why do so many retirees choose the lump sum? Benartzi et al. (2011) describe the annuitization puzzle: theory predicts that retirees would value insurance against living too long, yet few choose to annuitize voluntarily. They point to behavioral factors, including how the choice is framed and the appeal of a large balance, along with fears about losing control or dying early and receiving little. A lump sum looks like wealth; a pension looks like a paycheck, even when the paycheck is worth more.

My uncle took his lump sum at 62, invested it with a broker and withdrew heavily in his first years, including a boat and help for his children. By 75 he was living on Social Security alone. His pension option would have paid for life, and my aunt would have been protected after he died.

I would recommend the joint-and-survivor pension. It protects his wife, who may outlive him by many years, and it is backed by the plan and, within limits, by the Pension Benefit Guaranty Corporation. Because the monthly pension amount will never rise, they should keep their savings invested to offset inflation and delay Social Security to raise their inflation-adjusted income.

Reply to Rachel

Rachel, your thread recommended the lump sum because it gives the retiree control and something to leave his children, and you mentioned that your own parents valued leaving an inheritance. Those are legitimate goals that many retirees share, and Dalton and Dalton (2018) treat a lump sum as a sound choice for some retirees, especially those in poor health or with ample other guaranteed income. In the thread's case, though, the lump sum would need to support withdrawals well above a cautious rate to replace the joint pension, which puts the wife's security at risk in exactly the scenario a pension is designed for, a long life. Benartzi et al. (2011) note that retirees often undervalue annuities because the monthly amount looks small next to a large balance, and the desire to leave a bequest is one of the reasons they cite. One way to honor both goals is a partial approach where the plan allows it, or, if it does not, taking the joint pension and using other savings or a life insurance policy for the inheritance. A modest term or permanent policy could leave the children a known amount while the pension secures the couple's income. My grandparents did something similar, and their children received the insurance proceeds while my grandmother lived on the pension for twelve years after my grandfather died. Your thread made me think harder about the bequest motive, which planners can easily overlook when they focus on income. Would your parents' goals be met by separating the income decision from the inheritance decision?

Reply to Daniel

Daniel, I agreed with your recommendation of the joint-and-survivor pension, and your point that a guaranteed check protects a retiree from poor investment decisions in a market decline was well made. Your experience watching coworkers lose savings in 2008 made the argument vivid. I would add one risk the pension does not cover, and it is the one retirees most often underestimate: inflation. Most private defined benefit plans pay a fixed amount with no cost-of-living adjustment, so the $2,550 monthly benefit will buy less each year. At 3 percent inflation, its purchasing power falls by roughly a quarter in ten years and by nearly half in twenty. Dalton and Dalton (2018) note that Social Security, by contrast, is adjusted for inflation each year, which makes the timing of Social Security claims an important complement to a fixed pension. Delaying Social Security raises the inflation-protected part of the couple's income, while the pension covers the early years. Benartzi et al. (2011) also explain that people tend to underweight longevity risk, and inflation compounds that risk because the longer the couple lives, the more their fixed pension erodes. Keeping some savings invested in assets that can grow helps offset the decline. A simple rule could guide them: spend the pension and Social Security first, and draw on investments only to restore lost purchasing power as prices rise. Reviewing the plan every few years would show whether the gap is widening faster than expected. Would you pair the pension with a plan for when each spouse claims Social Security to manage the inflation risk?

References

Benartzi, S., Previtero, A., & Thaler, R. H. (2011). Annuitization puzzles. Journal of Economic Perspectives, 25(4), 143-164. https://doi.org/10.1257/jep.25.4.143

Dalton, M. A., & Dalton, J. F. (2018). Retirement planning and employee benefits. Money Education.