Archives for August 2022

A reader writes in, asking:

“The age old question: Lump Sum or Monthly Payment? A few years ago it was considered lunacy in the office for anyone who took the Monthly vs Lump option. With increasing interest rates the Lump option today is significantly smaller than last year – and stability of guaranteed income the Monthly is looking more attractive in today’s climate. How does someone figure out – optimal choice, not just Lump vs Monthly, but, if you go Monthly understanding the financial tradeoff on choices of survivor percentage, to “X year Certain and Life Annuity” and “Cash Refund Unpaid Balance” payment options. How do you figure out what is the better option – or at least what you are trading off on one vs the other?”

For pension decisions, when looking at the decision for a client, I typically take two approaches.

First is the quick/easy approach, which is to compare via an online annuity quote provider, such as immediateannuities.com. I’ll put in a given premium (e.g., $100,000), and see what is the annual percentage payout available, for a person who is the age in question (or for a couple of the applicable ages).

And then that percentage payout can be compared to the percentage that is available as the pension annuity option (i.e., annual income, divided by alternative lump sum). Sometimes what you’ll see is that, relative to what’s available in the private marketplace, the pension annuity option is a very good deal or a very bad deal, which then makes the decision relatively easy. Often though, the answer is that it’s a roughly “fair” deal.

And I’ll repeat that process for each pension option for which there is a comparable annuity option. Sometimes you’ll find that one of them is clearly the best deal, actuarially. One limitation of the above method though is that there are often a broader range of pension payout options (especially survivor options) than comparable options on annuity websites.

The second approach is to do an expected present value comparison. For a single person, that’s essentially asking what is the person’s life expectancy, and then “discounting” those expected payments (from the lifetime annuity option) to determine the present value, and see whether that is meaningfully higher or lower than the amount available from the lump sum. (This article has steps for doing a present value calculation in Excel.)

For a married couple, it’s the same general concept but a bit more involved. In that case, I use this spreadsheet (credit to #Cruncher on the Bogleheads forum) to calculate how likely each of the mortality scenarios is for each year going forward (i.e., probability both people are alive, probability only personA alive, probability only personB is alive, probability neither person is alive). And then for each year I multiply those probabilities by the benefit payment in question (i.e., payment if both people are alive, payment if only personA is alive, and payment if only personB is alive). And then I discount all of those probability-weighted cash flows back to their present value, and see how that compares to the lump sum option.

When doing an analysis similar to the above, it’s important to use varying mortality assumptions to see how sensitive the results are to such changes. And the results should be treated as a rough conclusion, because we don’t know how long you (and/or your spouse, if applicable) will live. So, for example, if two options are only a few percentage points apart in terms of expected present value, rather than concluding, “ah, this option is better,” I think a more appropriate conclusion is, “these two options are very similar.”

In addition, all of the above is purely dealing with the actuarial expected payout. And there are two other factors to consider as well: taxes and longevity risk.

With the Social Security filing decision, tax planning is usually a point in favor of waiting (because Social Security benefits are themselves tax-advantaged). But with the pension decision, it could point in either direction, or neither.

From a longevity risk point of view, the annuity option (if married, the annuity option with the highest survivor benefit) is generally the better option, though as per the above discussion it could make sense to take the lump sum and buy an annuity elsewhere. In addition, for people whose desired retirement spending is very modest relative to available resources, longevity risk is already very low. So a further reduction in that risk isn’t particularly valuable.

Most research on retirement spending strategies accounts for longevity risk and market risk. They account for longevity risk by simply assuming that you live to an advanced age. And, after making that assumption, various modeling is done with regard to investment returns, with the conclusion generally being that it’s prudent to spend from your portfolio at a pretty low rate early in retirement, because you might get bad market returns (especially in the critical early years of retirement).

That’s all well and good. It’s an important takeaway — because of market risk and longevity risk, a low initial spending rate is a good idea. (What “low” means depends on circumstances, especially your age, current interest rates, and stock market valuations.)

But most such research still leaves out a major source of risk that exists in real life. Specifically, most such research assumes that your amount of annual spending is something over which you have complete control. But anybody who spends even a few moments thinking about it realizes that that’s just not the reality.

Maybe your car needs to be replaced unexpectedly. Maybe you have a major home repair that isn’t covered by insurance. Or maybe you end up needing 10+ years of expensive chemo treatment. Or you need several years of nursing home care or in-home care. Or maybe there’s a pandemic which ends up causing a large amount of unexpected inflation soon after you retire.

Spending shocks happen in real life. And, critically, they can occur in years in which your spending plan actually calls for reducing your spending.

For example: imagine you’re using a spending plan that calls for you to spend a given percentage of the portfolio each year based on your age. At your current age, you’re supposed to spend 4.5%, and your portfolio has declined over the last year, which means the dollar amount of spending is supposed to be reduced. But you also just learned that you’re going to need a particular medical treatment which you sure as heck aren’t going to skip. And that means that you’re going to be spending 7% of the portfolio balance this year — and likely next year as well — regardless of what the spending plan says.

That’s a big point in favor of a low initial spending rate — to build in “wiggle room” for such spending shocks. In a recent piece of research, Wenliang Hou for the Center for Retirement Research at Boston College found that, for retirees, the risk from health costs was actually greater than the risk from market uncertainty. And that’s just looking at one source of spending shocks (albeit probably the largest source, with inflation being the other largest potential source).

It’s also a point in favor of doing regular updates to your financial plan throughout retirement to see if you’re still on track and to see what adjustments should be made (to the extent that they can be made). As the late Dirk Cotten once remarked, “retirement finance has no cruise control.”