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Kitces on the eternal "Lump Sum vs. Pension" question
Old 07-22-2015, 09:00 AM   #1
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Kitces on the eternal "Lump Sum vs. Pension" question

The article is an informative primer on the factors involved and the framework that can be used to analyze this question that pops up so frequently.

kitces.com/how-to-evaluate-the-pension-versus-lump-sum-decision-and-strategies-for-maximization

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The bottom line, though, is simply this: the decision of whether to take a pension or lump sum is ultimately driven by the retiree’s ability to use the lump sum to re-create what the pension would have paid anyway. Depending on the retiree’s life expectancy, and the implied internal rate of return of the pension payments relative to the lump sum, it may be relatively easy to create a comparable portfolio return to replace the pension payments, or not. The only way to know is to evaluate each, one by one!
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Old 07-22-2015, 09:06 AM   #2
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One big flaw in that article - the GATT rate (30 year treas rate which isn't even published any longer) hasn't been used to calculate minimum lump sums for private plans (IRC 417(e)) in almost a decade, almost all plans use the PPA three-tiered corporate bond rate, which typically stays fixed during a plan year.

With a three tired rate, the single equivalent interest rate actually varies by individual.


One other thing to note, the IRC 417(e) mortality table is a 50/50 blend of male/female mortality which is a big deal. I didn't see that in his article anywhere but I just skimmed it.
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Old 07-22-2015, 10:04 AM   #3
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Unfortunately, if it isn't easy to produce comparable a pension payout using the lump sum offered, it could be the lump sum is just too small, or it could be that the pension promise is unrealistic and will be unilaterally abandoned at some future date. Whatever guarantees or backing behind the pension promise is also very important.
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Old 07-22-2015, 10:20 AM   #4
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And whether plans allow for a lump sum payout.

At the megacorp where I used to w*rk, they went thru several changes of corporate ownership and as such I have two different pension plans.

When I FIRE'd, only one of the plans allowed for a lump sum payout.

Makes the decision kinda easy.
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Old 07-22-2015, 10:26 AM   #5
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Our pensions are through CalSTRS. The annuity formula is based, while not directly but at least in some sense, on the pension funding base which includes employee, employer and state contributions. The lump sum is only the employee portion (which is less than half of total contributions). So the IRR/hurdle rate is very high and made annuitization a no-brainer.
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Old 07-22-2015, 12:01 PM   #6
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i got ultra lucky. took the discounted lump sum payment, put it in the market and within 8 months have grown it to equal what I think the full value was before the discount. (I took the 10 year certain monthly payout # and did the math that way.)

now my quandary is what to do with the money now that I have achieved my goal.

it's now sitting at VG in a variety of funds. I am torn between capital appreciation/growth and preservation.
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does your pension pass the 6% test?
Old 09-08-2015, 02:46 PM   #7
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does your pension pass the 6% test?

When You Should Take the Lump Sum Over the Pension | Clark Howard

From the article:

Think of it in terms of the 6% rule, or “does your pension pass the 6% test?”

If your monthly pension offer is 6% or more of the lump sum then it may be worth considering. If it’s below 6%, then you can likely do just as well (or better) by taking the lump sum and investing it, and then paying yourself each year (a form of your own personal pension that you control).

Here’s how the math works:
Take your monthly pension offer and multiply if by 12, then divide by the lump sum offer.

Example 1: $1,000 a month for life beginning at age 65 or $160,000 lump sum today? $1,000 x 12 = $12,000 divided by $160,000 equals = 7.5%.

In this case, you would have to make approximately 7.5% per year on the $160,000 to earn a steady $12,000 a year. Earning 7.5% a year consistently and forever is a tall task, so taking the monthly amount here (7.5% is greater than 6%), tells me that the monthly amount may be a better deal long term.

Keep in mind, part of what a pension is doing is technically just paying you back your own money. On your own, you can withdraw 5% per year from any lump sum (even if the funds are earning 0%), and the money should last for 20 years (5% x 20 years = 100% withdraw).

Twenty years is a long time…especially when you may not begin a pension until age 65. Twenty years will get you to age 85 using 5% each year in an environment where you make a zero percent return. My point in bringing up this math is that any monthly pension you elect to take over a lump sum amount should be well north of a 5% annual return/payment (that’s why I set my rule of thumb at 6%).

At least for the first 20 years, a 5% withdraw rate will give you an “income” by simply paying yourself with your own money.

Example 2: $708 a month for life or a $170,000 lump sum today? $708 x 12 = $8,496 divided by $170,000 equals a 5% payout. In this case, the monthly pension amount is offering you a return (for life) of about 5%. Remember, for the first 20 years earning zero, you could do the same before you run out. All you have to do is make a very modest return (call it 2% per year), and you would be forever ahead of what the company’s monthly pension would do for you. In this case 5% is less than my bare minimum benchmark of 6%, so you would likely be better off taking the lump sum of $170,000.

Other factors to consider:
  1. Your age to begin a monthly pension vs. the lump sum.
  2. Your projected longevity. The longer you live the more valuable the monthly pension amount will likely be worth to you.
  3. The type of pension payout you elect. Is it based just on your life and then stops after you die, or does it continue for your spouse’s life as well? Is there a “period certain” option that would be paid to your beneficiaries for a set number of years even if you pass away soon after taking the monthly pension?
  4. The solvency of the company “promising you the pension” for 20 plus years, and does the Pension Benefit Guaranty Corporation (PBGC) back up your payments if your former company paying the pension goes out of business?
  5. Will you at some point need a “lump sum” amount of money for an emergency? Maybe you already have that covered with other accounts or resources, so think of the lump sum offer in the context of other assets on hand.
Bottom line: There's a lot to consider when it comes to the lump sum vs. pension question. The first step is to do the math, and see if the monthly pension amount at least passes the “6% test.” Then beyond the 6% test consider how the other variables (above) tip the scales towards a monthly amount or a lump sum.


Me: Mine DID pass the 6% test. Mine was 10.6%. My answers on the other factors to consider were favorable. So, I will be keeping the pension plan in place and NOT taking the lump sum payment.
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Old 09-08-2015, 03:36 PM   #8
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Quote:
Originally Posted by ronin View Post
Our pensions are through CalSTRS. The annuity formula is based, while not directly but at least in some sense, on the pension funding base which includes employee, employer and state contributions. The lump sum is only the employee portion (which is less than half of total contributions). So the IRR/hurdle rate is very high and made annuitization a no-brainer.
Agreed. It's similar with us.

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Originally Posted by Happily Retired View Post
Me: Mine DID pass the 6% test. Mine was 10.6%. My answers on the other factors to consider were favorable. So, I will be keeping the pension plan in place and NOT taking the lump sum payment.
Asked my co-worker who's been working for 30 years now. His lump sum right now is $200,000 (just return of employee contributions + interest based on treasuries, no employer share or investment returns). Expected pension is $70,000 a year + COLA (CPI or 3% whichever is lower). Definitely a no-brainer particularly given we don't have Social Security.
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Old 09-08-2015, 07:41 PM   #9
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It's pretty simple to do a present value calculation on the back of an envelope, in excel or with an online calculator so you can back out the IRR on an annuity. The article from Howard Clark isn't very clear about the distinction between payout rate and IRR and his analysis doesn't account for COLA. Without a COLA the IRR cannot ever exceed the initial payout rate, but with a COLA the IRR can eventually exceed the initial payout rate.

I would not take the pension/annuity in Clarks first example even though it is above his "6% rule". A 65 year old man is expected to live 18 years. with his numbers that gives an IRR of 3.3%.....I'd rather use a stable value fund, keep my principal and bet on the interest rate going up. However if there is a 3% COLA the IRR jumps to 6.1% so that looks like a far better deal.

Clark's second example is ridiculous if the person is 65 years old as someone's life expectancy at that age is 18 years so a 5% payout implies an IRR of less than 0%.

Other factors to take into consideration are obviously your health, your heirs and how much you want to pass on, how the pension fits in with the rest of your AA and your need or desire for income generators other than dividends, capital gains and interest.
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Old 09-09-2015, 11:22 AM   #10
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If you all could indulge me, let me give a real world example. Let's say I leave my Megacorp employer today, at age 47. Pension is non-COLA'd, no survivors benefits, I'm not concerned about Megacorp or pension solvency, my longevity is about 82.

Lump sum taken at 65 would be $404k or I could choose an annual payout of $31k. That would put me above the 6% rule at 7.6%. So that would indicate that I should take the annuity option.

One other question though. If I were to take a lump sum upon termination I would receive $153k now. Taking the lump sum now vs waiting until 65 indicates a IRR of 5.6%. That would seem to be a pretty good "guaranteed" (assuming I don't die before 65) rate of return that I could 'count' as the bond portion of my asset allocation. I'm currently 75/25 stocks/bonds in my investment accounts. Would the best choice to take the lump at 65?
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Old 09-09-2015, 01:13 PM   #11
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If we assume you will live 18 years past 65 then your 31k from a 404k lump sum is an IRR of about 3.5%. Ask yourself if you are happy with losing that much principal for that guaranteed rate of return....obviously it will be less if you die early and a better deal if you beat the odds and live into your 90s.

If you have the option to take the $153k and let it ride until 65 and get $404k as a lump sum that does give you a 5.6% annual return over 18 years (47 to 65). Personally if someone were to guarantee me 5.6% per year for 18 years I'd take it in a shot. My choice would be to leave the money in Megacorp pension plan and probably take the lump sum at 65. Of course I'm not factoring in the possibility that they change the rules on you.
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