Ford's retiree cashout: A trap for the unwary

(MoneyWatch) COMMENTARY Ford Motor (F) recently announced that it would offer a lump-sum payment to 90,000 salaried retirees and former employees in exchange for their voluntarily forgoing all rights to future lifetime monthly pension payments. Although other U.S. companies have made similar offers to former workers who had yet to start collecting their pensions, the auto giant's proposal to current retirees is the first of its kind for a major domestic enterprise.

If enough retirees accept the cashout offer, Ford will reap significant financial benefits. First, it would reduce the volatility on the company's financial statements that results from its pension obligations. Second, Ford wouldn't need to pay premiums to the Pension Benefit Guaranty Corporation, the federally mandated organization that backs certain defined-benefit plans, on behalf of any retirees who accepted the lump-sum deal.

Ford also would likely be able to extinguish its pension liability at below-market rates for retirees who accept the offer. To understand what I mean, consider a retiree who was receiving a monthly pension of $1,000 per month and took the cashout. If the lump sum were calculated according to the minimum amount required by IRS regulations, and if the retiree took the payment and bought an "immediate annuity" from an insurance company, he or she would receive less than $1,000 per month.

The reason for the lower monthly payment is that annuity purchase rates that are prevalent at insurance companies today are higher than the amounts allowed by IRS rules for lump-sum cashouts. I demonstrated this in a recent post by showing that a fixed amount of money buys a higher monthly pension amount under federal tax regs compared to annuity amounts from insurance companies. Reverse this transaction and it costs more to buy a fixed amount of a monthly pension from an insurance company compared to the rates allowed by the IRS. I don't have access to the rates Ford will be using to calculate the lump-sum payments, but I'm guessing that they'll use the minimum rates allowed by under IRS rules. Conversely, it's entirely possible the company will use rates that are more favorable than the minimum required.

A good deal for retirees?

If a company had made this offer to me, I'd be extremely careful about considering it. That's because such lump-sum cashouts represent a trap for people who are unwary of the risks of trying to generate a lifetime retirement income. The biggest danger -- not knowing how long you'll live. Lump-sum cashouts are calculated assuming that the recipient will have an average lifespan. So if you take the money and live longer than your projected life expectancy, you've sold yourself short. On the other hand, a monthly pension offers a financial guarantee: If you live a long time, you'll have a retirement paycheck coming in for as long as you live, no matter how long that may be.

Another risk is that if you take the lump sum and invest it, you may lose some of your money due to stock market volatility or increases in interest rates. In fact, this is exactly the risk that Ford wants to off-load through its cashout program. By contrast, your monthly pension is immune to stock market and interest rate fluctuations.

Here's one more important advantage of a monthly pension: It's user-friendly. Your check comes in the mail or gets deposited automatically in your bank account, and you don't have to lift a finger to make that happen. This is particularly important as you get older and are less able to manage your finances yourself. It's not uncommon for elderly people to lose their life's savings due to fraud or mistakes -- a monthly pension makes this unfortunate situation almost impossible.

Can a lump-sum payment make sense?

Yes -- if you and your spouse are in poor health and expect to die earlier than your projected life expectancy, then you might realize more money with a lump-sum payment. A cashout also can make sense if you don't need the monthly pension and you want to leave a legacy to children or charities.

Worried that your employer will go bankrupt and won't be able to pay your monthly pension? That's only a risk if your monthly pension is significantly larger than the monthly amount guaranteed by the PBGC (The current guarantee is $4,653 per month for a single life annuity that started at age 65.) Guarantees are different for joint-and-survivor annuities or if your pension started before age 65. If your pension is much bigger than the PBGC guarantees and you're concerned that your employer could go bankrupt, that can be another reason to take the lump- sum cashout.

Learn more about the pros and cons of lump sum payments from pension plans by reading my previous posts:

Pension plan lump sum payments: Why you should avoid them
Pension plan lump sum payments: Arguments for taking them
Cash balance retirement plans: Annuity options

You can also read a longer article on my website that goes into more detail about the pros and cons of lump-sum cashouts, and more details about the potential loss of benefits in the event of an employer bankruptcy. This article includes a checklist of the pros and cons to help you decide whether to take a lump-sum payment from a pension plan.

If you're offered a lump-sum cashout of your pension, the best advice I can offer is to take the time to investigate the pros and cons as they apply to you and your particular circumstances. If you need professional advice, don't seek counsel from someone who also wants to invest that money for you -- you can guess what their answer would be. Instead, find someone who charges by the hour, and make it clear that you won't be working with them to invest the money for you if you elect the lump-sum payment. This will increase the odds that your advisor's recommendations will be unbiased.

Whether to elect a lump sum cashout from a pension plan is one of the most important financial decisions you'll make for the rest of your life. Don't blow it.