Author Topic: Does buying time in my pension make sense?  (Read 14313 times)

Jackhole

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Does buying time in my pension make sense?
« on: September 04, 2012, 07:26:40 PM »
I am a member of a state government pension system and have the opportunity to "buy time" toward my service length. What this means is, I have a 25-year pension, but have the opportunity to buy 1.5 years of time from government service in another state. This will cost me about $7500.

Now, to complicate matters more, we also have the ability to buy time straight-up at a higher rate up to a maximum of five years. In my case, I could buy five years for about $67K.

So, what I'm asking is, does it make sense to pay $75K for the ability to retire from my job 6.5 years early? I can't wrap my head around whether or not this is a good financial decision or not. This purchase would give me a full pension in 13 more years. I'll be 42 at that point.

arebelspy

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Re: Does buying time in my pension make sense?
« Reply #1 on: September 04, 2012, 07:58:50 PM »
So, what I'm asking is, does it make sense to pay $75K for the ability to retire from my job 6.5 years early?

I'm not sure this is correct, but assuming it is... Hell yes?

Imagine you are 42.  Would you rather work 6.5 more years to age 48/49 and at that point have an extra 75k in the bank?  Or would you be okay with 6.5 less years working, and 75k less in the bank?
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Jackhole

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Re: Does buying time in my pension make sense?
« Reply #2 on: September 04, 2012, 08:14:55 PM »
So, what I'm asking is, does it make sense to pay $75K for the ability to retire from my job 6.5 years early?

I'm not sure this is correct, but assuming it is... Hell yes?

Imagine you are 42.  Would you rather work 6.5 more years to age 48/49 and at that point have an extra 75k in the bank?  Or would you be okay with 6.5 less years working, and 75k less in the bank?
It's absolutely correct. It's a defined-benefit pension plan, 53.5% of the average of my highest three years salary. If I purchase 6.5 years for roughly $75K, they will let me retire at 17.5 years instead of 25 years.

I'm confused about your example though. The extra 6.5 years won't get me an extra $75K, it'll get me somewhere around $166K, conservatively*.

*This was figured by subtracting the pension salary over 6.5 years (~$191K) from my estimated full salary 12 years from now over 6.5 years (~$357K). Does that make sense?

Let's confuse things a little more and tell you that I can easily cashflow the $7500, but would have to take a loan, if anyone would even give me one, for the $67K. Also, this loan would severely limit my contributions to retirement savings outside of my pension plan.

bogart

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Re: Does buying time in my pension make sense?
« Reply #3 on: September 04, 2012, 08:16:33 PM »
So, what I'm asking is, does it make sense to pay $75K for the ability to retire from my job 6.5 years early?

I'm not sure this is correct, but assuming it is... Hell yes?

Imagine you are 42.  Would you rather work 6.5 more years to age 48/49 and at that point have an extra 75k in the bank?  Or would you be okay with 6.5 less years working, and 75k less in the bank?

No, no.  It's would you rather work 6.5 years more, or pay $75k (have $75k less) when you retire.  You can pay to buy time in the system (basically, to increase your pension payouts, per an existing formula), or, you know, you can not pay, in which case if you nonetheless continue working, you still accrue time and thus end up at the same spot (in terms of pension payout) at some point in the future.

My DH and I looked at this choice (for him) and decided against it.  But it's really a function of the pension system, its formula for calculating payouts, its stability (will you collect at the promised rate?), how many years you are from collecting the pension (and/or retiring, since you can likely collect the pension and work for a different employer, but not retire, if you want to), and what you expect the rate of return to be if you invest the money on your own rather than buying time in the pension system.

Or in other words, it's a question that's likely complex enough that if you're seriously considering it, it's necessary at an absolute minimum to sit down with a serious and detailed spreadsheet that really incorporates accurate values (and estimates) for the system in question and your circumstances within that system, or (gasp!) paying an hourly fee to a trained professional to run the calculations for you and make some recommendations.  IMHO. 

Another Reader

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Re: Does buying time in my pension make sense?
« Reply #4 on: September 04, 2012, 08:29:13 PM »
This is a complicated question and requires some fairly sophisticated math.  It depends on how long you intend to stay with this employer, at what point you become vested in the pension, what percentage of your salary per year worked you will receive at retirement, and how likely you are to receive raises and promotions.  You may not be able to use the time bought to retire earlier, it may just augment your pension when you do retire.  You should check with the HR folks about how your pension system works.

If you have reached the point where you are vested, typically it is worth buying the time from another system, at least in my experience.  At 1.5 years, you would likely not have been vested in the other system.  You may have received a refund of your contributions when you left, it depends on the system.  If that's the case, you would essentially be transfering over your time at a low net cost.  In general, you cannot buy time to bring your years of service to the vesting level.  There is some risk in buying time if you are not already vested. 

You would have to calculate the difference in the pension annuity at the time you intend to retire and present worth the estimated payment difference for the two different purchases.  You can be sure the folks that run your pension system made those calculations when they priced the time you are allowed to purchase.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #5 on: September 04, 2012, 08:35:36 PM »
This is a complicated question and requires some fairly sophisticated math.  It depends on how long you intend to stay with this employer, at what point you become vested in the pension, what percentage of your salary per year worked you will receive at retirement, and how likely you are to receive raises and promotions.  You may not be able to use the time bought to retire earlier, it may just augment your pension when you do retire.  You should check with the HR folks about how your pension system works.

If you have reached the point where you are vested, typically it is worth buying the time from another system, at least in my experience.  At 1.5 years, you would likely not have been vested in the other system.  You may have received a refund of your contributions when you left, it depends on the system.  If that's the case, you would essentially be transfering over your time at a low net cost.  In general, you cannot buy time to bring your years of service to the vesting level.  There is some risk in buying time if you are not already vested. 

You would have to calculate the difference in the pension annuity at the time you intend to retire and present worth the estimated payment difference for the two different purchases.  You can be sure the folks that run your pension system made those calculations when they priced the time you are allowed to purchase.
I agree that it's complicated, the more I think about it and weigh the options, the more I realize just how complicated a decision it is.

Just to clarify a few things. I am vested in my current retirement system, but was not in the previous one. The 6.5 years would allow me to subtract that time from the 25 years needed to retire, not simply add them on to the end. Whether or not I was vested or withdrew contributions from my previous system has no effect on this. It's a straight 16% a year purchase price for the 1.5 years of service I talked about and 35% for the other 5. I'm very confident that this is the way that service purchase works, I've done my homework on that end.
« Last Edit: September 04, 2012, 09:50:56 PM by Jackhole »

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Re: Does buying time in my pension make sense?
« Reply #6 on: September 04, 2012, 09:02:00 PM »
My math tells me you have worked for this employer for 5.5 years.  You must be 29, because in 13 years you will be 42.  You are vested in this system, so any time you buy should also be vested.

The purchase of the 1.5 years for $7,500 looks like a pretty good deal.  It looks like you are getting 2.14 percent of your highest three years of salary for every year of service at the original retirement age (53.5%/25 years).  If you averaged $100,000 in your highest 3 years, you would get an additional 3.21 percent, or $3,210 per year, if you worked the full 25 years and retired at 48/49.  If you averaged $50,000, you still would get $1,605.  Do the present worth calculation to see what your rate of return would be if you lived another 30 or 40 years after retiring.

I'm surprised your system does not have a minimum retirement age.  Both systems I worked in had minimum retirement ages of 50.  You may see that implemented in your state at some point as a way of controlling pension costs.

Norman Johnson

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Re: Does buying time in my pension make sense?
« Reply #7 on: September 04, 2012, 09:07:23 PM »
To complicate things, does your employer match your contribution? I was on leave and was offered the choice to buy my time on leave if I wanted. I only bought the time period where my employer matched my contribution because I wanted the free money.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #8 on: September 04, 2012, 09:18:08 PM »
My math tells me you have worked for this employer for 5.5 years.  You must be 29, because in 13 years you will be 42.  You are vested in this system, so any time you buy should also be vested.
Correct on all assumptions.
Do the present worth calculation to see what your rate of return would be if you lived another 30 or 40 years after retiring.
Can you elaborate on this, please?
I'm surprised your system does not have a minimum retirement age.  Both systems I worked in had minimum retirement ages of 50.  You may see that implemented in your state at some point as a way of controlling pension costs.
No sign of one yet. They did just increase both our and our employers' contribution rate by 1%, increased the service time to 27 years for new members, and increased the vesting time to eight years for new members.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #9 on: September 04, 2012, 09:23:12 PM »
To complicate things, does your employer match your contribution? I was on leave and was offered the choice to buy my time on leave if I wanted. I only bought the time period where my employer matched my contribution because I wanted the free money.
Yes, they do, but it doesn't matter if you take a full pension. This is a defined-benefit pension plan (annuity), I make 53.5% of the average of my highest three years from my retirement date, until I die. Statistically, retirees in my line of work will only live 5-10 years after retirement, so I guess the state is hedging their bets.

The only way your example would make sense would be if I left before retirement and rolled my account balance over into another investment vehicle.

arebelspy

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Re: Does buying time in my pension make sense?
« Reply #10 on: September 04, 2012, 09:29:17 PM »
You misinterpreted my thought experiment.  In essence, if you didn't buy time, you'd have an extra 75k that you DIDN'T spend on buying the years (and yes, whatever you earned in the meantime).  If you bought it, you'd have 75k less in the bank (cause you'd have spent it on buying those years).

So now pretend you are at age 42.  Would you rather retire right then, and have 75k less in the bank than you could otherwise (because you spend it on the pension), or would you rather work 6.5 more years and have that extra 75k (plus, yes, whatever you make in the meantime - irrelevant for this comparison).

In any case, the reason why I said it may not be correct is that it's much too simplified.  This is a much more complex question than that.

I have the option of buying years on my pension, as does my wife. We also have the option of taking them early (at a penalty per year that it's taken before fully eligible).

I have a spreadsheet with about 15 different scenarios (buy years versus not, retiring at various ages with and without the penalty) that graphs the break-even times for given rates of return (I.e. retiring 5 years earlier gets you more money sooner, good if you die earlier, but if you wait and retire later, you could catch up to one extra years of payment with the higher amount).  So one scenario is better if I project we live until 75, another at 80, etc. etc.

Plus my pension has a COLA and kicks in and increases different percentage amounts after certain years, so starting that earlier is also nice, so that's taken into account in the spreadsheet.

And, of course, the better the return on money taken early the better taking it early seems.

In any case, it is certainly going to be a highly individualized decision.  To purchase the years for myself and the wife it'll cost ~75k.  Probably going to do it, and retire 10 years before eligible, based on the curve I prefer the most among those graphs.  (FWIW, I plan to be FIRE long before taking the pension, even with taking it 10 years early, so it will in no way affect my ER date.)

Your mileage will vary quite a bit, most likely.
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bogart

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Re: Does buying time in my pension make sense?
« Reply #11 on: September 04, 2012, 09:33:53 PM »
Let's confuse things a little more and tell you that I can easily cashflow the $7500, but would have to take a loan, if anyone would even give me one, for the $67K. Also, this loan would severely limit my contributions to retirement savings outside of my pension plan.

I'm dubious about the likely merits of borrowing to purchase in a pension system, barring your having inside knowledge about your circumstances that make your case exceptional (you have a medical condition likely to prevent you from working until you qualify to collect the pension and that pension includes health insurance coverage in addition to a monthly check, for example).  At a guess, the $7500 might make sense, the $67K is less likely to.

If you invest $75K on your own, today, in 13 years you'll have $180K, assuming a 7% annualized return net of expenses and costs.  Of course if you borrow to ditto, you'll have to subtract those expenses out, and that's true whether you borrow to buy years in the pension system, or to invest on your own.

If you want a sense of where your state falls in terms of how well funded its pension system is, relatively to liabilities, this link might be helpful:  http://www.nasra.org/resources/S&P0903.pdf .  Note that state (public) pensions are not covered by the insurance plan that protects (some fraction of the benefits of) private pensions in the US.

Personally I wouldn't go borrowing money to buy time in a pension plan without consulting with a financial advisor knowledgeable about my state's pension system and its future prospects, but that's me.

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Re: Does buying time in my pension make sense?
« Reply #12 on: September 04, 2012, 09:42:48 PM »
Does your system only use years of service and not retirement age for calculating pensions??

Let's say you worked an additional 20 years making 25 years of service (rounded) and then lived 40 years after you retired.  If you received an extra $3,210 for those 40 years, you would have to discount that income stream for the time value of money.  You pay out $7,500 today, receive no payments for 20 years, and then receive 40 annual payments of $3,210.  Your rate of return is the discount rate at which those future payments discount back to $7,500.

Sadly, the battery in my HP12C has died and I can't make that calculation for you.  But someone out there can and you can plug in your estimate of the additional pension amount for that person to make the calculation.  Of course, this is oversimplified, but it gives you a rough idea of the return on your $7,500 investment.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #13 on: September 05, 2012, 07:44:19 AM »
Does your system only use years of service and not retirement age for calculating pensions??

Let's say you worked an additional 20 years making 25 years of service (rounded) and then lived 40 years after you retired.  If you received an extra $3,210 for those 40 years, you would have to discount that income stream for the time value of money.  You pay out $7,500 today, receive no payments for 20 years, and then receive 40 annual payments of $3,210.  Your rate of return is the discount rate at which those future payments discount back to $7,500.

Sadly, the battery in my HP12C has died and I can't make that calculation for you.  But someone out there can and you can plug in your estimate of the additional pension amount for that person to make the calculation.  Of course, this is oversimplified, but it gives you a rough idea of the return on your $7,500 investment.
There is no additional pension amount. It'll actually be slightly less, as I'll have spent $7500 to leave a year and a half early and therefore I'll have never gotten my last year's raise, so my income will be slightly lower when they calculate my annuity amount.

I think I've decided that the $67K for 5 years is a bad deal, but I'm now trying to decide if the $7500 for 1.5 years is.

Richard3

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Re: Does buying time in my pension make sense?
« Reply #14 on: September 05, 2012, 07:47:53 AM »
I think the best way to do this is in Excel.

Make three sheets / tables

No purchase.
1.5 purchase.
Purchase.

For each case, work out your expected money flow for each year (Salary / Pension and investment income / interest paid). Then do an NPV calculation for each series. Do it for a few different parameter combinations especially life expectancies / inflation rate but also ROI / Salary increase, loan repayment rate (your debt is an emergency so this may help your increase savings rate) and see if one situation is consistently better.

If I get bored tonight I might make a quick spreadsheet to do this.

arebelspy

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Re: Does buying time in my pension make sense?
« Reply #15 on: September 05, 2012, 07:49:07 AM »
I think I've decided that the $67K for 5 years is a bad deal, but I'm now trying to decide if the $7500 for 1.5 years is.

Why?

Don't just go with a gut feeling.

What are the numbers and logical reasons on why buying 5 years for 67k is a bad deal?

Also, have you looked into why is it 67k for 5 years?  1.5 years is 7500 (aka 5k for a year), so you'd think 5 years would be 25k.  Why is the purchasing price not linear? 

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arebelspy

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Re: Does buying time in my pension make sense?
« Reply #16 on: September 05, 2012, 07:50:25 AM »
I think the best way to do this is in Excel.

Make three sheets / tables

No purchase.
1.5 purchase.
Purchase.

For each case, work out your expected money flow for each year (Salary / Pension and investment income / interest paid). Then do an NPV calculation for each series. Do it for a few different parameter combinations especially life expectancies / inflation rate but also ROI / Salary increase, loan repayment rate (your debt is an emergency so this may help your increase savings rate) and see if one situation is consistently better.

If I get bored tonight I might make a quick spreadsheet to do this.

This is essentially what I described above.  Each scenario will have different payout times and break even points.  Generally the longer you live, the more it makes sense to buy as many years as possible.
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Another Reader

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Re: Does buying time in my pension make sense?
« Reply #17 on: September 05, 2012, 07:58:06 AM »
This is just an easy way of calculating the value.  It's one set of possible payments that equates to the $7,500 at some discount rate.  The other way involves forecasting two sets of pension payments for each scenario.  You could end up with a spreadsheet similar to that of Arebelspy.

The purchase from the other system may involve some reciprocity between the systems.  If the old system is kicking in unrefunded contributions by either the employer or employee, it's a way of getting money that would otherwise be lost.

bogart

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Re: Does buying time in my pension make sense?
« Reply #18 on: September 05, 2012, 08:24:44 AM »
Also, have you looked into why is it 67k for 5 years?  1.5 years is 7500 (aka 5k for a year), so you'd think 5 years would be 25k.  Why is the purchasing price not linear?

Our state pension system works this way, specifically if (as I believe the OP said applies in his case) you are buying in on the basis of time previously allocated to (employed by) another state government.  In our case there's no transfer state-to-state, it's just cheaper to buy pension time if you spent time in another state system.  I think of this as the state government version of professional courtesy; I don't think there's any deeply (or mathematically) logical reason for it, it just got written into the system somewhere.  How widespread it is, I don't know, but I assume the OP's state is similar to ours in this regard.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #19 on: September 05, 2012, 08:27:22 AM »
Our state pension system works this way, specifically if (as I believe the OP said applies in his case) you are buying in on the basis of time previously allocated to (employed by) another state government.  In our case there's no transfer state-to-state, it's just cheaper to buy pension time if you spent time in another state system.  I think of this as the state government version of professional courtesy; I don't think there's any deeply (or mathematically) logical reason for it, it just got written into the system somewhere.  How widespread it is, I don't know, but I assume the OP's state is similar to ours in this regard.
Exactly. 16% for military/public service elsewhere, 35% for non-qualified service.

I've got some more to say on some basic calculations I made on the $67K amount, but I've got to go to work right now.

Jackhole

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Re: Does buying time in my pension make sense?
« Reply #20 on: September 05, 2012, 05:46:42 PM »
Why?

Don't just go with a gut feeling.

What are the numbers and logical reasons on why buying 5 years for 67k is a bad deal?

Also, have you looked into why is it 67k for 5 years?  1.5 years is 7500 (aka 5k for a year), so you'd think 5 years would be 25k.  Why is the purchasing price not linear?
I would have to borrow the $67K, which comes out to about $500/mo. (not counting interest) for the next 12.5 years until I would retire, assuming I bought the time. If I invested the same $500/mo. into a Roth IRA until I turned 65 (which is what I would do anyway after the loan was paid and I retired and moved on to other employment), I'd conservatively have somewhere around $1.1M. Now, if I only invested that $500/mo. from ages 41 to 65 (because I couldn't afford hardly any other investing because all my money would have been tied up in the 5 year purchase loan), I would only have about $400K in the Roth. So I just lost $700K by buying the ability to retire 6.5 years early.

Now, what I'm trying to figure out is if the $7500 is worth 1.5 years or not.