Pensions: Understanding the Hurdle Rate

Contributed by: Nick Defenthaler, CFP® Nick Defenthaler

Monthly payments or a lump-sum? This is often times the “million dollar question” for those in the workforce who still have access to a defined benefit – a pension plan. As I’m sure you’re aware of, pension plans, in the world we live in today, are about as common as seeing someone using a Walkman to listen to music – pretty much non-existent. Most companies have shifted from defined benefit retirement plans that offer a fixed payment or lump-sum upon retirement to defined contribution plans such as a 401(k) or a 403(b) as a cost savings measure. However, if you’re lucky enough to be eligible for a pension upon retirement, the hurdle rate, or internal rate of return, is one of the more important, quantitative aspects about receiving a pension that will influence your decision to either take the lump-sum or receive fixed monthly payments.

What the heck is a hurdle rate?

To keep things simple, the hurdle rate, also known as the internal rate of return, is essentially the rate of return necessary for the investment of the lump-sum option to produce the same income as the fixed monthly payment option. One of the most important factors that will go into this calculation is life expectancy. Typically, the longer you expect to live the higher the hurdle rate will be because the dollars will have to support your spending longer. Let’s take a look at an example. 

Tom, age 65, will be retiring in several months and has to make a decision surrounding his pension options. He can either take a $50,000/year payment that would continue in full, even if he pre-deceases his wife, Cindy (also 65), or he could take a lump-sum distribution of $800,000 that his financial planner could help him manage. Tom and Cindy both have longevity in their family and feel there is a good chance at least one of them will live until age 95. If either of them lived another 30 years and they invested the $800,000 lump-sum, the IRA would have to earn a 4.65% rate of return to produce the same $50,000 of income the fixed payment option would offer. If, however, age 85 was a more realistic life expectancy for Tom and Cindy, the hurdle rate would decrease to 3.78% because the portfolio would not have to produce income for quite as long. 

Some financial planners would argue that 4.65% as a hurdle rate at age 95 is more than doable in a well-balanced, diversified portfolio over three decades, but others may not (check out Tim Wyman’s, CFP®, blog on how professional opinions can differ). While we certainly have our opinions on long-term market performance, the most important decision, in my opinion, determining between lump sum or fixed payments, is how the decision made will help you sleep at night. 

Keep in mind that this is just one of the many factors we help clients evaluate when making this important decision with their pension. While we wish there was a clear, black and white, right or wrong answer for each client situation, that’s virtually impossible because there are so many different variables that go into analyzing your financial options. We’ll help you look at and understand all of your options, but ultimately it’s your decision on what route you take depending on what makes you feel the most comfortable. In the end, at The Center we work with our clients to ensure that they can live their plan when they are ready and in a manner that they are confident with. When making important financial decisions, especially regarding your pensions, remember that we are here to help.

Nick Defenthaler, CFP® is a CERTIFIED FINANCIAL PLANNER™ at Center for Financial Planning, Inc. Nick is a member of The Center’s financial planning department and also works closely with Center clients. In addition, Nick is a frequent contributor to the firm’s blogs.

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Nick Defenthaler and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected. Diversification and asset allocation do not ensure a profit or protect against a loss. The example provided in this material is for illustrative purposes only.