Lump sum or monthly pension? How I made my decision

Advisers likely to hear this question from clients more often

Aug 17, 2014 @ 12:01 am

By Mary Beth Franklin

Recently, an investor wrote to me asking if he should accept his employer's offer of a lump-sum payout in lieu of a monthly pension. Of course, such a decision depends on a person's financial needs, life expectancy and access to other assets, so I encouraged him to consult a financial adviser.

But the question struck a chord with me, as I was offered a similar choice recently. And it is an issue that in the near future is likely to start coming up more frequently in conversations with clients.

“Many plan sponsors are settling their liabilities with former employees by offering them lump-sum cash-outs,” Jim Ritchie, a principal in Mercer's retirement practice, said in a recent report about pension plans sponsored by S&P 1500 companies.

The funding status remained relatively stable, at about 85%, during the first half of 2014, according to Mr. Ritchie. Pension plans must be at least 80% funded to allow employers to offer lump-sum buyouts to vested employees.

Another compelling reason for companies to transfer liabilities and risks to employees: major increases in Pension Benefit Guaranty Corp.'s per-participant premiums. The premiums, which are paid annually, will rise by more than 30%, to $64, in 2016, from $49 in 2014. They are tied to inflation thereafter.

“A buyout eliminates paying these annual premiums, along with other administrative costs, which are often a large part of the cost in maintaining the plan,” the Mercer report stated. “The current economic environment, together with the increase in PBGC premiums and mortality update on the horizon, makes 2014 an attractive time for sponsors to consider an annuity buyout as an effective risk management tool,” it said.

GUARANTEED BENEFIT

Frankly, until the letter arrived from a former employer in June offering me a lump-sum payout, I was looking forward to a pension of about $1,700 per month that I could start collecting in five years, when I turn 65. I felt lucky to have a guaranteed retirement benefit in this post-pension era. But at the same time I was disappointed, because the amount could have been so much larger had the plan not been frozen about 10 years after I became eligible to participate.

After much deliberation and consultation with my financial adviser, I decided to take the lump sum.

Some people may be surprised by my decision, as I am such a big proponent of having sufficient guaranteed income to cover fixed costs in retirement. The combination of a pension and a smart Social Security claiming strategy can go a long way to pay for many of those recurring costs.

But selecting a lump-sum payout now will allow me to create an even bigger monthly benefit in the future.

RATE-DEPENDENT

Using the federal government's current low interest rates of 1.17% for the first five years, 4.29% for the next 15 years and 5.36% thereafter, my monthly annuity translates into a lump sum of about $207,000 today. If I wait five years until my normal retirement age of 65 to collect, the lump sum value drops to about $189,000 under current interest rate assumptions. If interest rates rise, it would require a smaller lump sum to generate the same monthly benefit.

For most clients, taking a lump sum transfers the risk of lifetime income from the employer to the employee. You must be careful in accepting that risk and determining how to invest the money to provide adequate income for life.

I was fortunate. I owned a deferred variable annuity with living benefits inside my individual retirement account and was able to roll over the entire lump sum into that investment vehicle.

The annuity guarantees a minimum rise of 6% a year — possibly better, depending on the market performance of my aggressively invested subaccounts — and the guaranteed balance resets at the highest point each year.

If the money earns the minimum guaranteed rate of 6% a year, my lump sum payout will be worth about $277,000 when I turn 65 — about a third more than it is today. If the market performs better than the guarantee, I could come out well ahead.

Of course, as several InvestmentNews readers have correctly pointed out, the minimum annual increase applies only to the guaranteed balance that is the basis for annuitizing the contract. If instead I want to take periodic withdraws subject to contract limits, they would be based on the actual account balance that reflects the performance of the underlying investments. In a worst case scenario, I could deplete the actual account balance, and I still have the right to annuity payouts for the rest of my life.

I know many people argue that it is ridiculous to put a tax-deferred annuity inside a tax-deferred IRA. It's the old belt-and-suspenders argument.

But frankly, when I bought the annuity during the ugly days of the market crash of 2009, I was more concerned about guarantees than tax deferral. I'm happy with my choice, and it's a guarantee that I doubt I could match today.

There likely will be a large number of pension buyouts in the near future. Be ready with appropriate answers for clients who ask for guidance about their choices.

This article has been updated to clarify that the 6% minimum annual increase applies only to the guaranteed balance that is the basis for annuitizing the contract.

(Questions about Social Security? Find the answers in my e-book, available at InvestmentNews.com/MBFebook.)

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