Annuity or Lump Sum Payment? (Part IV)

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 the third post we discussed alternatives for investing a lump sum. In this post we’ll consider how much money you can safely withdraw each year.

Deciding how much you can withdraw leads right back to this question: how long are you going to live? The shorter your life span, the more you can “pay yourself” each year. With one year, all the money is yours to do as you wish. If you want to keep the inflation adjusted principal to give to your favorite charity (which may be your kids) you can only spend the real return each year. With long TIP real returns less than 1.75%, you need a huge pile of money to live off the income. For example, to pay yourself $50,000 a year that will increase with inflation, a 1.75% real rate of return means you need to have $2,857,000. Those are the extremes; what about the rest of us?

Okay, so no one has given you a look into their crystal ball to determine your date of death. You are going to have to guess. If you guess too many years, you didn’t use your money wisely—some will be left over. If you guess too few years, you are penniless when you live past the date you guessed.

Let’s say you have a nest egg of $1,000,000. With a real rate of return of 1.75%, if you only expected to live ten years, the first year you can take out $108,000. Planning to live twenty years? You can withdraw only $59,000. Thirty years? Only $42,000. Forty years? Then $34,000 for you in year one. The next year you get an increase to cover inflation during the year.

Taking on more risk (add equities, corporate bonds, etc. to your portfolio) in order to increase your expected real rate of return works well if you start when markets are low; poorly if markets are at their top. How do you know which is which? You don’t, except in retrospect. We all know trying to time the markets doesn’t work well for most of us.

Wait, you say, I Googled it and depending on my age websites tell me I’m safe to take out 4%, 5%, 6% a year. Do they guarantee you won’t run out of money? No, they don’t. The more sophisticated models give you a percentage chance that you’ll be okay. Which is great if your life is a Monte Carlo simulation where there are hundreds of thousands of you who live to various ages and get various results on their investments. But you are only one person.

Yeah, you say, but I like that 95% probability from the simulation.

And I say the only way you are going to do that is if a very large part of your portfolio is made up of annuities where you have no mortality risk and you’ve minimized the inflation risk as much as you can (see post 2).

I’m glad we have that settled!

~ Jim

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

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

Annuity or Lump Sum Payment? (Part I)

For me, the choice was easy. My defined benefit pension plan didn’t allow for lump sum payments, so the only question I needed to answer was the form of the annuity. My defined contribution pension plan didn’t allow an annuity, so lump sum it was. In this discussion I will use generalities regarding taking a lump sum from a defined benefit pension plan.

Lump sums are determined based on the defined benefit otherwise payable, interest rates and mortality assumptions. The law defines minimum and maximum lump sums; the pension plan itself contains the rules for determining your specific lump sum. I could regale you with atrocities plan sponsors and financial advisors perpetrated on plan participants in the bad old days; but the law was changed and those abuses are no more.

If you are going to die the day after you receive the distribution, taking a lump sum is a great idea for your estate. Clearly, if your expected mortality is significantly worse than assumed in determining the lump sum you are better off taking the cash now.

If you don’t expect to get personally acquainted with the grim reaper in the near future, then a lump sum is not a clear winner—even with historically low interest rates. Before the next post, I want you to think about what risk you should be trying to mitigate. (Here’s a hint: it’s not about dying too soon.)

The next blog will explore the risk that should be paramount in your decision-making and what that means.

~ Jim

Social Security May Plug the Payback Loophole

I’m sure this provision in Social Security started life as someone’s altruistic idea to help out folks who made a poor decision. Essentially, the payback works like this: you can restart your Social Security benefits to eliminate any early retirement reductions and take advantage of delayed retirement credits with one small hitch—you need to pay back any benefits you received with interest.

What’s wrong with that? If someone made a bad choice, why not give them a do-over? Because the only people who can take advantage of this payback option are those with enough money on hand to pay back all their previous Social Security benefits. That does not include most people.

Let’s take a simplified example that ignores the effect of cost-of-living adjustments and interest charges. Mr. Former Wage-Earner started benefits in 2005 at age 62 at the rate of say $10,000 per year. His full retirement age was 66 (in 2009). If Mr. Wage-Earner had waited until 2013 to start benefits they would have been (again ignoring COLA adjustments and Wage Base Increases) roughly $17,500.

Under the payback rules, he could stop benefits, pay back $80,000 (8 years at $10,000/yr.) and for the rest of their life get $7,500 more per year in benefits. Still ignoring interest, as long as he lives to age 81, he’s ahead of the game.

Since most retirees should be much more worried about longevity risk than the date they break even, this is an excellent deal for those in decent health since it provides 75% more benefits for folks who live to ripe old ages, mitigating the risk of living longer than money lasts. Further, if you compare this deal from Social Security to the cost of purchasing a life annuity with full CLOA from an insurance company at age 70, you’ll discover this is a also an excellent monetary deal from that standpoint.

Because people are using the payback for other than “oops” situations, the Social Security Administration wants to change the rule so it only applies for the first year after Social Security benefits start, which covers the purported original intent of the provision.

If you want to take advantage of this loophole (1) get top-notch investment advice about whether this makes sense and all of the ramifications, and (2) hurry—the loophole may not last long.

~ Jim