Annuity or Lump Sum Payment? (Part II)

In the previous post I asked you to think about the risk you should be trying to mitigate as you consider the lump sum vs. annuity issue.

Most people’s greatest risk is outliving their money and relying on Social Security. Annuities can mitigate that risk, but not eliminate it. Life annuities will continue for as long as you live, but most pensions do not adjust benefits for increases in cost-of-living. You've lessened, but not eliminated your risk of outliving your money when you choose an annuity over a lump sum. This risk of outliving assets applies not only to the person receiving the annuity or lump sum, but also to a spouse or partner.

If you are married, you can take your annuity as a joint and survivor form to allow continuation of some or all of your pension after your death. The payments will continue as long as your spouse lives. Your benefit is reduced to pay for this insurance. All other things equal (although they rarely are), I suggest the joint and 75% or 66-2/3% options because one person cannot live well on half the income two had. For example, if you own a house or rent an apartment, you’ll need more than half the space if you decide to move and if you don’t move, your rent or real estate taxes stay the same.

If you have an unmarried partner, you have the same considerations, except many corporate pension plans will not allow joint and survivor benefits. Then you need to look carefully at what happens when you die, and how much income needs to be continued. Perhaps a life annuity will be fine because the partner has sufficient retirement assets to take care of himself. If not, then either you can take the lump sum (see the third blog in the series for problems with lump sums) or some portion of the monthly benefits will need to be set aside to take care of the partner.

Let’s say the partner needs to have the equivalent of a 50% of the pension annuity income continued after the annuitant dies. To use an example, let’s say the annuity is $2,000/month and if you were allowed to take a joint and 50% survivor benefit, your benefit would be reduced to $1,800 to cover the cost of the survivorship benefits. Actual reductions depend on the age differences between the partners and pension plan specifics. If that option isn’t available, you can look at how much life insurance you can purchase on your life for $200 a month. (To simplify I am ignoring taxes here.)

Purchasing guaranteed renewable term insurance might be a good way to fill in the gap, essentially buying the survivor benefits from an insurance company instead of from the pension plan. It’s not as efficient, but it can work.

I should mention that if the need for post-mortem income is limited to a fixed period of time, plans often allow optional benefit forms of 5-, 10- or 15-years certain. Under those annuity forms, if you die before the end of the certain period, the benefits will continue for the remainder of the guaranteed 5, 10 or 15 years, as elected. Note: these forms of benefit are only useful if there is some need of finite years (for example a child’s education) that you are trying to protect. Do not use a years-certain option in lieu of joint and survivor options for a life-income need.

How can you handle the issue that most annuities do not have inflation protection? It takes discipline, but here’s one approach: Determine (you can do this online or have your friendly insurance agent or financial advisor get the information for you) how much your annuity would need to be reduced to get inflation protection. It’s rare for an insurance company to provide full protection, so you may need to settle for a proxy to determine an estimated cost – such as using an annuity that automatically increases benefits 3% or 4% a year.

Let’s just say your original $2,000 per month annuity must be decreased to $1,333 per month in order to provide full COLA protection. In year one, you will need to invest the $667 monthly difference between your standard annuity and what it would be with future COLA adjustments. In year two, the annuity will continue to pay you $2000, but let’s say there was some inflation and the $1,333 would have grown to $1,375. In year two, that’s the amount of your pension you can spend and the rest ($625/mo.) you will invest. (Again, I’m ignoring taxes.)

At some point the $1,333 increased by cumulative COLA differences will exceed the $2,000; let’s say it is $2,025. Then you are taking the entire annuity and making up the $25 difference by dipping into your savings.

Will it work perfectly? Not at all. On average, for a very large number of people it might work out well, but some people will die before they exhaust the savings made up of “scrimping” in the early years. For some, inflation will be less than expected and they too could have spent more in their earlier years. For others the opposite will be the case. Perhaps inflation runs higher than expected – or you live much longer than average. In both cases you should have spent even more in the very early retirement years, and now you will have to cut back in your later years.

Not a perfect solution by any extent, but at least with the life annuity, the nominal payment is guaranteed for as long as you live. For lump sums, the issue is even worse.

Next up in Part III, what happens when you take the lump sum instead of an annuity.

~ Jim