Registered Investment Advisor specializing in Model Portfolios

SJun 20, 2012

Pensions: When a Bird in the Bush Can Be Worth More than a Bird-in-Hand

Scott Burns

Q. The subject of whether to take a company pension or a life annuity is slim pickings when surfing the net. I plan on retiring within the next 12 months. I have the option of a $560,000 lump sum payment or a $37,200 annual pension (no cola). My spouse would get half that income upon my passing.

If I take the lump sum I would have a total of $1,200,000 in assets. Using a 4 percent draw down rate, that would allow me to retire with a projected income of $48,000. If I take the $37,200 pension and draw on my $640,000 retirement account at 4 percent the income would total about $62,800 ($37,200 pension plus $25,600 from the investment account). With the exception two fee-based advisors everyone says take the lump sum.

What am I missing? —W.V., Flower Mound, Texas

A. You're not missing anything. This is not an easy decision. It has a lot of moving parts and all kinds of uncertainty. Provided that your pension fund is well funded— that it has assets to back its promise of a lifetime income— the prudent decision is to take the pension, not the lump sum.

Here's why. That $37,200 annual income amounts to a 6.66 percent annual distribution from the $560,000 lump sum. While it won't increase, it will mean that you won't be so dependent on your other financial assets. To have a $48,000 annual income from your pension and investments, for instance, you would only need an additional $10,800 a year in income from the $640,000 you have, or 1.7 percent a year.

That's less than you could earn in a broad index of common stocks. This means you could enjoy a rising income as dividends increase, regardless of the ups and downs of stock prices. More important, it means you would not be trying to squeeze 4 percent out of $1.2 million and, very likely, selling stocks to do it. It means you could avoid the need to sell equities in the early years of your retirement. This works, studies have shown, to increase the odds that you won't outlive your money.

A 2002 study for TIAA-CREF by John Ameriks, Robert Veres and Mark J. Warshawsky showed that using a portion of your retirement assets to buy a life annuity would increase the probability of being able to make withdrawals from the remaining assets for 30 years. A balanced portfolio without an annuity investment, for instance, was estimated to have a 76.3 percent chance of survival. But if 25 percent of the money was invested in a life annuity the probability rose to 85.1 percent. Invest still more and the survival probability for most portfolios rose to about 95 percent. (You can read the earlier column on this here.)

There are psychological benefits as well. If the combination of your Social Security benefits and the corporate pension is enough to cover all your basic expenses (including your income taxes) you will experience a remarkable freedom. You will also be able to use your financial assets with greater flexibility. Retirees who depend on their savings for every dime over their Social Security income are having a very tough time coping with the current zero interest rate policy of the Federal Reserve. It amounts to an indirect tax on people with savings, who tend to be older people.

Q. What is the "break even point" of when to take Social Security monthly benefits when I reach full retirement benefits at age 66? —W.L., Houston, TX

A. Once you reach full retirement age your benefits will increase by 8 percent for each year of deferral. Since future benefits are also adjusted for inflation, this means your break-even in real purchasing power is about 12.5 years— that’s when you’ll have received as much in additional benefits as you gave up by delaying them. At age 66 the life expectancy of the average American (all races and both genders) is 17.8 years. Life expectancy for a 66-year-old white male is 16.3 years. As a consequence, deferring benefits is a good bet. You may also enjoy some tax savings since deferring benefits for a few years can help you avoid the their taxation.

Filed Under: Retirement