Archives for August 2022

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Pension Choices: Lump Sum or Monthly Payment?

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.

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Can I Retire Cover

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Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: Inflation Reduction Act – Environmental Credits for Homeowners

The Inflation Reduction Act (signed into law last week) includes extensions, expansions, and renaming of a few environmental-related credits for homeowners. CPA Beth Nelson has a great write-up with the details:

Recommended Reading

Thanks for reading!

 

Why Do Advisors Recommend Complex Portfolios?

A reader writes in, asking:

“After talking to a few investment advisors who I’m considering using, as well as reading articles and books written by other advisors, it really appears to me that advisors create portfolios that are more complex than is really necessary. Do you see that as well? And if so, why do you think that’s the case?”

I do agree that many advisors tend toward complex portfolios, but I will also note that there are some who like to keep things simple. For example, most of the advisors from the Garrett Planning Network with whom I’ve spoken are fans of very basic “total market” index fund or ETF portfolios. The same goes for various advisors from the Bogleheads community, such as Allan Roth, Rick Ferri, and Jon Luskin.

But let me back up a step first. There’s isn’t necessarily anything wrong with a complex portfolio. The primary drawback of portfolios with many moving pieces is simply that they’re more work to manage. But if you already know that you intend to hire an advisor to manage the portfolio for you anyway, that’s a non-issue.

I think there are three possible reasons for the preference for complex portfolios among advisors.

The most positive possible reason is that advisors are in fact better informed than DIY investors, and their preference for more complex portfolios is simply the result of better information. Frankly, I have my doubts. I’m unconvinced that a sliced and diced portfolio with 7-10 different funds is meaningfully better than a simple three-fund portfolio.

Then there’s a more neutral reason — one based on simple human nature. As people who were drawn to working in the financial services industry, it’s likely that advisors think portfolio construction is neat. It’s fun. So they have a natural inclination toward portfolios with many different holdings.

Finally, there’s a more negative/cynical explanation. It has to do with marketing.

By showing you a complicated portfolio and the research behind it, an advisor looks smart — or at least, that’s how many prospective clients would see it. Compare that to, for example, the opposite end of the spectrum: if an advisor told you they were going to put your money into a target-date fund, many people’s natural response would be “well then why am I even hiring you?”

And presenting you with a complicated portfolio is almost a no-lose proposition from the perspective of the advisor. If it helps with the sales process, it means more clients and more revenue. And the additional complexity is not a major drawback for a full-time professional with portfolio management software.

And the complexity provides a degree of client “stickiness.” That is, if you’re already somebody who is inclined to have an advisor manage the portfolio for you, the more complicated the management of the portfolio appears to be, the less likely you are to want to switch to a DIY approach at some point.

Investing Blog Roundup: Two-Minute Financial Checkup

Jonathan Clements’ Humble Dollar website recently released a neat little calculator that they’re calling the Two-Minute Financial Checkup. It asks a few easy questions, and then provides you with a list of planning points you should be considering.

Of course, requiring only minimal input from the user is both an upside and a downside. (It’s easier to get somebody to try it out. It’s harder for the calculator to provide detailed output.)

Recommended Reading

Thanks for reading!

The Third Reason to Use a Conservative Spending Rate in Retirement

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.”

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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