Lots of times, we get buried in the weeds of analysis and lose sight of the main objective. A good case in point is the lump sum versus pension payout decision. If you are lucky enough to work for an organization that offers a pension plan, when you retire you might be asked to decide if you want a stream of payments over a set period of time or until you or your spouse die, or a lump sum all delivered today; or some combination of these choices! There are plenty of quantitative approaches to help get to the “right” answer for YOU, but it is best to start at the top and then drill down. Following is the thought process we use at Dattilio & Ash.
Taking a pension as a stream of payments is a valuable benefit for some people. It removes your responsibility to manage investment risk and provides “guaranteed” payments over a set time frame, either until you or your spouse die or over another set time frame. The guarantee is only as good as the pension sponsor’s ability to manage the plan effectively, however, but even if they run into trouble there is a federal guarantee program to help backstop their guarantee.
Sounds good so far, but there are some negatives. The actuaries determine your pension payout based on your life expectancy; live longer and economically you are a winner, die early and you lose since you only get payments shorter than expected! Embedded in your pension payment, in addition to other expenses, is this mortality charge that helps set your payment. Another negative is that most pension plans offer only “fixed” payments and do not include adjustments for inflation (the notable exception is Social Security!)
So, how do you decide what is best for you? First thing is to recognize your current and expected financial situation. Since pension payments are calculated assuming some level of mortality risk and other expenses, if you can “self-insure” this risk you are saving economic value for yourself. The key determinant to help decide if you can self-insure is your amount of liquid investments. If you are fortunate enough to have accumulated a large investment portfolio that is materially sufficient to cover all your expenses and goals during your retirement years, you likely do NOT need to pay the expenses embedded in pension payments and can instead use your investment portfolio to replicate pension payments customized to your specific needs.
Here is a case study with real numbers to show how this works. Let’s assume that you have the option of receiving either a $350k lump sum or $25k per year until you die. Which do you choose?
First thing is to calculate a simplistic break-even point; the point where the sum of all payments equates to the lump sum, assuming some net investment rate. Embedded in this pension payment is a 0% interest rate that results in a break-even point of 14 years ($350k/$25k); live longer than 14 years and you win, shorter and you lose. Another way to look at this is to evaluate if you think you could earn more than a 0% net investment rate over the next 14 year. Though there are no guarantees, I can pretty much assure you that the capital markets will net return more than 0% over the next 14 years.
So, if you have the capability to self-insure investment risk and mortality risk, taking the lump sum is an economically preferable solution. Alternatively, if you need (or want?) the benefit of a guaranteed payment into the future, then the pension payment is the right solution for you. At Dattilio & Ash we can help you go through the decision process to get to the right decision for you.