Pension - Lump Sum or Annuity?

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bakerjin
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Pension - Lump Sum or Annuity?

Post by bakerjin » Wed Nov 14, 2018 11:45 am

Hi everyone, I am qualified for a very small pension from a previous employer. I haven't worked there since 2009 so the pension will not increase nor is it inflation adjusted.

I am eligible to "cash out" and receive a lump sum payment at any time. This will be tax deferred if I roll it over into an IRA.

Here are some numbers:
Lump sum in 2018: $14,731
Lump sum in 2046 (age 65): $56,384
Annuity in 2046: $427.15 per month

These annuity numbers seem pretty abysmal. If I assume a 7% inflation adjusted return on the stock market, if I took annuity from ages 65-90 (good case scenario), I'd receive $133,270. However, if I just took the lump sum of $56,384 at age 65, in 25 years it would have grown to $306,021 thanks to compound interest.

Furthermore, if I just took the $14,731 this year (as small as that sounds), it would have grown to $97,944 by age 65 and $531,584 by age 90.

Am I missing something? It seems like taking the lump sum would be best if I don't need to touch it (and I'm fairly certain I won't "depend" on this annuity at age 65 so I would just invest it). Is there any scenario in which I should not take a lump sum? And if not, should I take it now or at normal retirement age (or somewhere in between)?

Thanks in advance for your help!

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AtomicCash
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Re: Pension - Lump Sum or Annuity?

Post by AtomicCash » Wed Nov 14, 2018 12:09 pm

My guess is that a group of actuaries have crunched the numbers to come up with a lump sum and an annuity that are statistically equivalent for a large sampling.

Are you sure you accounted for market returns on the annuity? 25 years of $427.15 per month is $128,145 with no market gains. When I do the calc with 7% interest over 25 years, I come up with about $345,000

Marc

bakerjin
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Re: Pension - Lump Sum or Annuity?

Post by bakerjin » Wed Nov 14, 2018 12:29 pm

Ah you're absolutely right, I wasn't accounting for market returns on the annuity! Thanks so much, I should have known I was missing something.

With that thrown into the calculation, it looks like my "break even" point would be around age 83, when the market returns on the lump sum would be 190,574 and the market returns on the annuity would be 191,597.

However, it still doesn't beat the market returns of just taking the lump sum this year as early retirement ($14,731 now, $531,584 at age 90). If I reduce the expected return to 6% instead of 7%, it becomes much closer though.

Guess this isn't as clear cut as I thought. What would y'all recommend in this scenario?

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Watty
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Re: Pension - Lump Sum or Annuity?

Post by Watty » Wed Nov 14, 2018 12:38 pm

bakerjin wrote:
Wed Nov 14, 2018 11:45 am
Am I missing something?
A few things,

1) You need to know what happens to the money if you die before you start the pension. In some cases your estate may get nothing. If you are single then this may be more of a risk since a spouse would normally get the pension if you die.

2) Taxes, there are lots of factors including the possibility of taking the lump sum in an IRA then doing a Roth conversion.

3) One option would be to take the lump sum and leave it invested until you are in your late 70's then buy an an annuity with those funds if it makes sense then.

4) With the pension you have a lot of inflation risk and you might not "break even" until you are 80 or older so if there is high inflation anytime in the next 40 years it could be worth very little by then.

5) The option to take the lump sum may not be available in the future. I had a similar small pension like that were they took the lump sum option away for about five years because the pension was underfunded. They eventually allowed lump sums again but if you hit 65 during those five years you had to take the pension.

6) How is the lump sum amount calculated? My old pension was a cash balance that was guaranteed to grow by 5% a year or more depending on government bond interest rates. The 5% was a lot better than I could get with a bond so I decided to leave the money in it. That 5% was set years ago when it sounded ridiculously low. Some people have posted about 3% being used now, or it may not be a cash balance plan so there may not be a simple percentage like that.
bakerjin wrote:
Wed Nov 14, 2018 11:45 am
Is there any scenario in which I should not take a lump sum? And if not, should I take it now or at normal retirement age (or somewhere in between)?


When people have a pension like they they are sometime reluctant to change anything, this is call anchoring.

I would turn the question around and ask it this way, "I have $14,731 in an IRA, should I buy a non-inflation adjusted deferred annuity with the same terms?" (You can actually buy these but people rarely do.). When you look at it this way most people would not be at all tempted to buy it even if it is mathematically a good deal.

I would probably take the lump sum unless there is some special situation like #6 above.

123
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Re: Pension - Lump Sum or Annuity?

Post by 123 » Wed Nov 14, 2018 12:45 pm

In many cases the lump sum payout alternatives for pensions are calculated using interest rates established by the IRS. Often if this is the case you may see a reference to them as in your payout option calculation (sometimes referred to as Segment 1, Segment 2, Segment 3). The IRS calculations are sensitive to interest rates. While your monthly pension options may not be impacted by changes in interest rates the lump sum alternative often are. Because interest rates are still comparatively low it's possible that the lump sum benefit payable now may be higher now than it will be if you wait a few years because higher interest rates will reduce the lump-sum payout alternative generally.
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bakerjin
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Re: Pension - Lump Sum or Annuity?

Post by bakerjin » Wed Nov 14, 2018 4:25 pm

Thanks everyone!
Watty wrote:
Wed Nov 14, 2018 12:38 pm
A few things,

1) You need to know what happens to the money if you die before you start the pension. In some cases your estate may get nothing. If you are single then this may be more of a risk since a spouse would normally get the pension if you die.
I'm married but my annuity will be reduced if I want spousal benefits... for example, $380/month for 50% spouse benefit if I die. I wasn't planning on taking this option since we're the same age but I guess I could.
2) Taxes, there are lots of factors including the possibility of taking the lump sum in an IRA then doing a Roth conversion.
I was planning to move my lump sum into an IRA with a direct rollover which they confirmed will be tax deferred (if I do take the lump sum).
6) How is the lump sum amount calculated? My old pension was a cash balance that was guaranteed to grow by 5% a year or more depending on government bond interest rates. The 5% was a lot better than I could get with a bond so I decided to leave the money in it. That 5% was set years ago when it sounded ridiculously low. Some people have posted about 3% being used now, or it may not be a cash balance plan so there may not be a simple percentage like that.
I'm actually not sure how it's calculated. I was on the phone with the retirement department and they would calculate the lump sum whenever I asked them a year (this year or full retirement year).
I would turn the question around and ask it this way, "I have $14,731 in an IRA, should I buy a non-inflation adjusted deferred annuity with the same terms?" (You can actually buy these but people rarely do.). When you look at it this way most people would not be at all tempted to buy it even if it is mathematically a good deal.

I would probably take the lump sum unless there is some special situation like #6 above.
These are all great points. In response to your question, I don't think I would buy an annuity with the money, so it sounds like a lump sum option may be the best bet. It's just sad since $14,731 doesn't seem like a lot right now compared to a guaranteed $427/month, but I have to remind myself that the $427 is not inflation protected and I won't receive it until nearly 28 years from now. Hopefully parking the $14,731 in my rollover IRA with FSTVX and compound interest will be better in the long run.
123 wrote:
Wed Nov 14, 2018 12:45 pm
In many cases the lump sum payout alternatives for pensions are calculated using interest rates established by the IRS. Often if this is the case you may see a reference to them as in your payout option calculation (sometimes referred to as Segment 1, Segment 2, Segment 3). The IRS calculations are sensitive to interest rates. While your monthly pension options may not be impacted by changes in interest rates the lump sum alternative often are. Because interest rates are still comparatively low it's possible that the lump sum benefit payable now may be higher now than it will be if you wait a few years because higher interest rates will reduce the lump-sum payout alternative generally.
Thank you for this comment. I knew that payouts depended on interest rates but I didn't know how. Interesting to know that the lump sum may be higher now when interest rates are low...

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AtomicCash
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Re: Pension - Lump Sum or Annuity?

Post by AtomicCash » Wed Nov 14, 2018 7:29 pm

bakerjin wrote:
Wed Nov 14, 2018 12:29 pm
...

Guess this isn't as clear cut as I thought. What would y'all recommend in this scenario?
Another deciding factor may just be your personality. Are you the kind of guy who likes to have full control of the money and won't mind the inevitable bear markets over the next 25 years? Or would you sleep better during a 30% market correction knowing your $427 will come in next month just like it did last month?

Marc

radiowave
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Re: Pension - Lump Sum or Annuity?

Post by radiowave » Wed Nov 14, 2018 8:38 pm

OP you may want to check if you have additional retirement benefits that may not be available if you take the lump sum. E.g. I have a small state defined benefits plan like you but it is tied to a very generous Medicare Advantage plan that is part of a university healthcare system that will go away if I take the lump sum.
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