Q: In your column you frequently recommend taking a lifetime pension and not a lump sum. I could understand not putting the pension lump sum at risk, but it seems to me that taking a fixed pension over, say, a 25-year retirement has some problems. First, since there are no cost-of-living increases, the pension checks will remain fixed and won't keep up with inflation. Second, if something should happen to me and my spouse, the pension does not pay into our estate and benefit our heirs. Third, should the company fail and be unable to meet its pension obligations, we could lose out. So I would favor taking the lump sum and investing it in very safe assets, designed to produce income to us similar to what the monthly pension checks would have been. Am I missing something? -- P.K., Tucson, Ariz.
A: I know it is tempting to take the cash and assume that you will be able to invest it for a higher return and better annual income. But the brute fact is that it is difficult and expensive for the "retail" investor. It would be particularly difficult in the current low interest rate environment.
You also may not understand the benefit that a high and guaranteed income stream provides for the rest of your portfolio.
So let me give you an example. Suppose you have $100,000 in your 401(k) plan. You also have a pension cash offer of $100,000. That pension offer would buy an immediate joint life annuity for you and your spouse. Assuming a 100 percent survivor benefit to your spouse, the monthly income would be $569, according to www.immediateannuities.com. That's $6,828 a year, or a cash flow return of 6.8 percent.
You will not find a safe way, today, to get that much income. Remember, the yield on a 30-year Treasury is currently running at only 4.37 percent, according to www.bloomberg.com. Meanwhile, the high cash return will allow you to draw very little from the $100,000 in your 401(k) portfolio.
If, for instance, you decided to have an overall safe withdrawal rate of 4 percent from your entire portfolio, having half of it in the pension/life annuity would allow you to draw at only 1.2 percent ($1,200 a year) from the 401(k) account.
The greatest danger to retirees is that they suffer a series of losses in their first year of retirement. But a 1.2 percent withdrawal rate is lower than the dividend yield of many funds these days, so you could go for years before you would need to sell shares at a depressed price. Committing to a pension/life annuity works to make it more likely that you won't run out of money. Several studies have confirmed this idea.
Needless to say, you would opt for the lump sum if your company's pension plan was underfunded.
Q: Our youngest child graduated from college this past May. Since then we have been able to save a bit more money. By June 2009 we will have 42 months left on our mortgage of 6.8 percent, and the payoff is projected about $40,000. My question: Should we pay off the mortgage at that time or ride out the remaining few years? -- L.B., by e-mail
A: You didn't say where you lived or what your real estate taxes are. But there is a high probability you will receive no tax benefit from your mortgage interest payments. Why? The standard deduction may be greater than all of your itemized deductions. This year the standard deduction is $10,900 for a couple and $5,450 for a single-person household. The deduction will be higher next year when it is adjusted upward for inflation. Until your itemized deductions exceed the standard deduction, you won't save any taxes on your mortgage interest.
Many couples start running out of itemized deductions right at your life stage -- when the last kid is out of the nest.
So here is your task. Add up your itemized deductions. If the total is less than $10,900, paying off your mortgage is a slam-dunk investment. You'll save the $2,720 in mortgage interest. You'll eliminate the monthly mortgage payment, which will make it easy to increase your 401(k) contributions. And you won't have to pay income taxes on the piddling amount of interest you'll earn on the $40,000.