Sam’s question: “Our employer gives us a choice of either a pension or a lump sum when we retire. Which is better?”
You will have to get out a pencil and hand calculator to find the better choice, and it’s dependent on a lot of factors.
If you select the pension, it may be an annuity bought by your employer’s retirement trust from an insurance company or it may be funded by the trust or even the government on a pay-as-you-go basis. There are risks with any of these sources, and you’ll have to be the judge of that. In any event, you will be able to get quotes for different conditions. To do the analysis, you will first have to determine the options for survivor benefits if you have a spouse. The largest monthly benefit will be for no survivor benefit. Of course, this is so hard on the other spouse after your death that the law requires your spouse sign a statement agreeing to this. It’s common to have choices of 0%, 50%, 75% and 100% survivor benefit. The last choice gives the smallest monthly payment.
You don’t say whether the pension will be inflation-adjusted every year. If it is, the adjustments will likely be based on the Consumer’s Price Index, CPI, just like social security. Few employers offer plans with such adjustments except parts of the federal and state governments. For example, if you get a military pension, it will have the inflation adjustment. The finance companies usually assume an inflation rate under 4% when they price these, so you would definitely benefit in a high inflation environment such as we had in the sixties.
But most pensions and immediate annuities have fixed payments that continue until you or your spouse die. After that point, there is nothing to left for your heirs. This is basically a bet between you and the insurer. You hope you will live longer than the average person, but the insurer knows that more than half the people will die before the insurer runs out of money. The insurer also may have some healthy charges built into the quotes and the only choice you have is to go to a site like www.immediateannuities.com and compare your employer’s quote with those of other sources.
By far, the greatest problem with a fixed pension is the fact that inflation continues to erode its value. My own fixed pension lost 30% of its purchasing power in the first ten years—and that was in a time of relatively low inflation. In a moment, I’ll show you how to make a fair comparison of a fixed pension with inflation-adjusted payments either from a pension or taken as ever increasing withdrawals from the lump sum.
Now let’s consider the lump sum. If this is coming from an employer savings plan, then you want to make sure that you roll the money over into an IRA already established for this purpose. If you get the money in your own hands, you have just bitten off a tax problem that is very hard to digest because you’ve just withdrawn an amount that is fully taxable. A mutual fund will help you with the paperwork to avoid this problem. If you are under 59 ½, you also are subject to a 10% tax penalty.
If the lump sum is from a severance package, you will pay income tax, social security and Medicare tax on the proceeds. In this case, you will have to do an after-tax analysis of the comparison using after-tax values of the annuity (pension) payments. However, for the rest of your life, you will also be paying social security and Medicare taxes on each monthly check.
If you take the lump sum from a severance package and then decide to buy an immediate annuity to provide pension payments on your own instead of using the company offer, the calculation is more complex than shown below, so I suggest that you use the free “Evaluating Immediate Annuities” program for this purpose on www.analyenow.com.
If you take the lump sum—and invest it wisely—you can make withdrawals each year that will increase with inflation. In fact, the “Required Minimum Distributions” (RMD) from an IRA or 401(k) increase each year as you age to help counteract inflation. Basically, the RMD is last year’s ending balance of your savings divided by a conservative estimate of your current life-expectancy. I say conservative because the IRS adds several years to life-expectancy so that if you live longer than the average person you will not be trying to run on an empty investment tank.
There is an underlying assumption in the IRS rules that your investments will have a return on investment that is at least equal to inflation. You should be able to achieve this with conservative investments like treasury inflation protected securities, TIPS, sold by the federal government or, with a slightly lower return, sold by mutual funds. Good investors who augment their investments with low-cost stock index funds may do better than TIPS, but there is no guarantee. In fact large numbers of investors often have a hard time beating TIPS because they buy securities when their prices have nearly topped out and sell them at lows. Of course, both of these actions are just the opposite of what the perfect investor with perfect foresight would do.
So how do you compare a fixed pension with a payment that is inflation adjusted? First you have to line up the numbers. Since we are talking about retirement plan choices, the taxes for any choice are going to be at ordinary tax rates. (The comparison is more difficult for annuities that you purchase using funds from non-qualified accounts.)
The first number you’ll need is the amount you can draw from your investments. You’ll need to estimate the number of years you have till death, namely your life-expectancy. You can use the IRS tables from Publication 590 that you can find on www.IRS.gov. Or you can get a more personalized number from www.livingto100.com. Divide the amount in your retirement account by this life-expectancy, and you’ll get the annual amount you can spend from the lump sum. Each year your life expectancy goes down a little, so you in future years you divide by a slightly smaller life-expectancy which increases the size of the next year’s payments and compensates for inflation.
The second number you’ll need is the annual amount from the pension. To make a fair comparison, use the pension quote based on the 100% survivor payment option multiplied by 12 to get an annual amount. If it’s in inflation-adjusted pension, you can use the result directly, but if it’s a fixed pension quote, you’ll have to make the following simple adjustment to the annual amount. Multiply the annual payment by your age at retirement divided by 100. (This is a good approximation to the detailed financial equation adjustment that’s based on expectations of returns, inflation and life-expectancy.)
Now compare the two annual payments. If the payment from the lump sum is significantly better than the annual (adjusted) pension, chose the lump sum if you feel you can manage the investments. If the annual (adjusted) pension number is significantly higher than the payment from the lump sum, that may be the better choice.
But there are other considerations as well. If you don’t have any savings outside of the retirement account, you probably should pick the lump sum because you’ll have years with unexpected events that will need cash in excess of the annual payments. The pension has no fall-back position.
The other consideration is the difference in risk. This is virtually impossible to quantify, but
think about it anyway. The pension may
not continue making payments as large as promised if the trust or insurer is
weak. Payment failure may be a remote
possibility, but it has happened.
Further, if you are a government employee, the government may
unilaterally elect to reduce the payments—which it can do because it’s a
sovereign power. Many retired
Of course there is risk with the lump sum choice as well. Whether it will last as long as you live is dependent both on the securities markets as well as the amount you take out annually. One very prominent financial expert advised people to invest in 100% stock in a 1999 paper and said that they could withdraw 7.5% the first year and increase the withdrawals by the amount of inflation in all subsequent years—with, he said, very high success probabilities. Well, anyone who retired in 1999 or 2000 and took that advice would be in deep grease today. The remaining investments would be far too small to support many additional years of retirement. All because the stock market plummeted after 2000 and now, six years after very large draws, would take impossibly high returns to recover.
So the math is easy. The risks aren’t. If you think that the risks are acceptable for whichever result that the math shows is better, I’d go with the math, but I’d still want some reserves for the unexpected.
Married couples can gain some risk protection from the pension choice if they choose less than 100% benefit for the survivor. (The analysis above would not be a fair comparison if it was made using less than the 100% survivor benefit.) The risk protection could come from putting away some of the additional payment (compared to the 100% survivor option) into a reserve account if other reserves were inadequate. Nevertheless, if the choice is a fixed pension, retirees should not plan on spending more of the pension than the after-tax amount multiplied by their age at the time divided by 100. The remainder should go into savings to provide for inflation and be drawn down by the cumulative amount saved divided by the current life-expectancy.
Further, if you take the lump sum, remember to consider part of that for a reserve. You don’t want to plug the entire amount into a retirement calculator to find out how much you can withdraw each year for normal expenses. I can guarantee that you will have abnormal expenses of some kind.
Copyright © 2006 by Henry K. Hebeler. All rights reserved.