Should I Take My Pension in a Lump Sum?
Recently overheard on another financial website . . .
Question: "I'm 60 and have just retired. I have a pension that can pay me $760/mo. or a lump sum of about $120,000. I'm torn. Should I take the monthly payment format or the lump sum? It seems that I could take the lump sum and invest it elsewhere and do better job investing it. Right or wrong?" --Bill H., Birmingham, Ala.
Let's flesh this case out and see what ESPlanner suggests.
Let's give Bill a modest earnings history, $50,000 in regular assets, and $300,000 in a 401(k). Let's also assume that Bill's single, rents an apartment for $1,000 per month, and that his pension is a fixed annual amount of dollars, i.e., it's not adjusted over time for inflation. Finally, assume that Bill invests safely in Treasury Inflation Protected Securities (TIPS), which yield 2.5 percent per year after inflation.
If Bill cashes out his pension and takes the $120,000 available in a lump sum, his annual living standard is $14,114 per year for each year through age 100. Taking the defined benefit of $760.00 per month provides a living standard of $15,533. That's a 10 percent larger living standard for the next 40 years!
But what if Bill dies, say, at age 63? Well, since his kids are comfortable, the only one that will really miss Bill's money is Bill. But Bill will be in heaven where money isn't needed.
What if inflation takes off and goes to 10 percent immediately?
In that case, if Bill cashes out his pension and takes the $120,000 lump sum, his annual living standard is higher by 15 percent than if he takes the annual benefit. The reason is that inflation eats up the real value of Bill's annual pension. Indeed, by age 80, each dollar received by Bill from his pension is worth only 15 cents in terms of its real purchasing power.
So inflation is a real risk when it comes to deciding whether or not to cash out one's pension. Of course, were Bill's pension fully indexed for inflation, this concern would not arise.
Another issue in Bill's deciding whether to cash out his pension is whether his the company will be around for the next 40 years to meet its obligation to him. A lot can change in forty years. Forty years ago GM was the world's most successful automaker; today, it's barely breathing. The government does insure private pensions through the PBGC -- the Pension Benefit Guarantee Corporation. But were Bill's company and its pension fund to tank, the PBGC would pay only about 40 percent of what Bill would otherwise have received.
One way for Bill to avoid both the risk of his employer going bust and the risk of inflation is to take the lump sum benefit and then immediately purchase an inflation-indexed annuity from a reputable insurance company. At the moment the Principal Insurance Company appears to offer the best terms on such annuities via a website called www.elmannuity.com.
Another argument often made against annuities is that there is no guarantee one will live long enough to benefit from the investment. That's true, but annuities are insurance policies against living longer than expected. We don't play the odds when it comes to buying homeowners insurance, and we shouldn't play the odds that we'll die on time.
A final point raised against annuities is that Bill can earn a higher real return if he were to invest the $120,000 on his own. Hmm,... Maybe yes, maybe not. Economics can't say what will return Bill will receive. But it can and does tell Bill that once he accounts for the extra risk he's undertaking in trying to earn a higher return, there is no advantage to his investing on his own.