Annuity or Lump Sum Payment? (Part III)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In this post we’ll consider how to mitigate your risks when you choose a lump sum.

Many investment advisors recommend taking a lump sum instead of an annuity because of the annuity’s lack of inflation protection. That concern is legitimate (and discussed in the second post), but advisors commonly fail to mention the issue of your longevity. So what are their recommendations?

Variable annuities: The idea here is that the increase in the underlying value of the assets will fund ever increasing annuity payments. There is, of course, no direct link between inflation and equity prices. In the long run, equities have outpaced inflation, but in the long run we are also dead. The issue if you are retiring is all about the relatively short run of the next 30, 40 or 50 years.

Buying a variable annuity right before the most recent stock declines would put you in a very large hole that your annuity might not recover from. Fortunately, inflation is currently low, but it might not stay low. If you purchase a variable annuity, the payments will decline if the underlying assets decline, meaning you may end up with less than that fuddy-duddy annuity you cashed out of.

Also of note are the fees attached to many variable annuities. Those fees (going to your broker who suggested you take the lump sum—he gets nothing if you choose to stay with the company’s annuity) and the profit the insurance company thinks they should get for providing you the product and maintaining it over the decades, also mean there is less going into your pocket. Remember: the more for them, the less for you.

You can purchase variable annuities with certain levels of guaranteed benefits, which lessen the risk of a decline in the nominal benefit. Those annuities limit your upside potential in order to pay for covering the downside.

Alternatively, you might purchase a traditional annuity, without the equity element – but wait a minute, that’s what we had to start with. Years ago interest rates used by some pension plans to determine lump sums were lower than those used by insurance companies to determine annuities, so even with the commissions, fees, insurance company profits and the like you could make out on that kind of deal. Today, except under unusual circumstances (when interest rates have rapidly increased), no such a deal will be worthwhile.

How about TIPs? Treasury Inflation Protection bonds provide a floor in the case of deflation and match the CPI for inflation. The current real rate of return for long-term TIPs is less than 2%. Not going to get rich that way, but it at least provides protection.

Your advisor could suggest some mix of stocks, bonds and cash – and we know there are no guarantees with any mix, other than cash and its equivalents and those leave us subject to inflation.

But let’s say you’ve made your choice. Some combination of equities, TIPs, REITs, some foreign securities—a nice balanced portfolio. You know it can go up and down and you’re prepared for that. Now, how much are you going to take out each year?

We’ll discuss that question in Part IV.

~ Jim