Q: I am facing a difficult retirement-funding decision.
I am a 52-year-old municipal employee in Texas. I’m vested in a defined-benefit plan. It will provide me a lifetime annuity beginning at age 62.
I have the option of purchasing an additional five years of service for about $75,000. This will bump up my monthly annuity at 62 by $1,200 a month, which seems like a really good deal.
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What bothers me is that I have to rob my 401(k) for the $75,000. That means I have to give up its potential market growth for 10 years. How would you suggest doing a comparison of these options?
A: Giving up 10 years of potential market growth may not be so painful when you consider the apparent value of the annuity income being offered for that $75,000.
If you visit the website immediateannuities.com, you will find that a 62-year-old man in Texas would now have to pay $230,539 for a life-annuity income of $1,200 monthly if the annuity paid no benefits to any beneficiaries.
It would cost still more if there were any provisions for payments to beneficiaries.
To have that $230,539 purchase price available in 10 years, the $75,000 you need to commit today would have to grow at a stunning compound annual rate — 11.88 percent. That makes it a very good opportunity, with one really big risk.
What could that risk be? Just this: Do you think the municipality you work for can earn returns like that?
We are now at the beginning of a series of public-sector bankruptcies.
Most of them will involve government units that have promised future pension incomes without putting aside nearly enough money, or earned high enough returns to deliver the promised cash at the appointed time.
Most government entities base their pension promises on an actuarial assumption that the money they put aside will earn about 7.5 percent, down from somewhat higher assumed returns years ago.
Neither corporate nor public pension funds have earned 7.5 percent over the last 10 years. That’s why many pension funds are seriously underfunded.
Can they “catch up” in the future? With a 10-year Treasury yielding less than 2 percent today, it’s not very likely that pensions will earn 7.5 percent over the next 10 years, let alone 11.88 percent.
What you can be certain of is that anyone who is given the opportunity to buy years will be very tempted to do it: The retirement income offered is looking better by the day.
This means further stress on the pension fund and more pressure on pension managers.
It also means that you’re supposed to believe the folks who haven’t been able to make 7.5 percent in the past can make 11.88 percent over the next 10 years. That turns what you’ve been offered into a pretty risky bet.
Should you make the bet?
Yes, but don’t bet the ranch: Be certain that $75,000 is a relatively small portion of your existing 401(k) balance.
Copyright, 2013, Universal Press Syndicate