Another lump sum vs. annuity question

[DoingHomework]

Here's another annuity vs lump sum question, with a twist.

My wife can retire in about 1 year with several options. The baseline is a straight life annuity at about $4000 a month. Another option is a 36 month lump sum plus a lower life annuity. The lump sum would be 36 times the basic monthly payment for the straight annuity (i. e. about 36 times $4000 or $144000) and the monthly annuity payment for that option would be 73% of the base $4000 (about $2920) starting immediately.

To me the twist is that the basic assumed return behind the life annuity (no lump sum) is about 8%. I think that is a pretty good "guaranteed" return and it is from a healthy (relatively) state pension plan. The rub is that the pension is not inflation-protected but has historically given increases based on excess returns.

We don't need the cash up front. If she takes the lump sum it would be rolled directly into an IRA that she can't easily access for a few years. We'll be living off taxable accounts plus her pension for about 5 years and have adequate funds for that. I'll likely work for a couple of years after she calls it quits too.

My thinking is that even though 8% is a decent return (considering it is nearly guaranteed), it is better to have control of the cash just in case something happens with the pension. But, as I said, we believe the pension is sound so it is a close call. At 8% we're on the fence, 10% would likely push us to skip the lump sum while 6% would be a no-brainer to take it.

Another complication is that, if everything goes to plan we will get killed on taxes when RMDs start. I'm not sure I want to make decisions based on what tax rates might be 25 years hence but having more money in an IRA might not be desirable over a higher pension income. Along similar lines, if SS becomes overtly means-tested (which I expect), what is likely to be more penalized, pension income or IRA balance?

We realize we'll be throwing the dice either way but I'd be interested in hearing thoughts on this since my best stab at the math makes it a close call. I think some of the speculative factors are worth considering.

[Lcountz]

Excuse me and I'm sorry for jumping your post..how does one post a "new thread" or "new post"?

[REWahoo]

Click on "Forums" near the top left of the page, click on the forum where you want to start a new thread, then click on "New Thread" at the top left.

[gauss]

For me a key question about your decision would be what type of other liquid assets or income streams do you have at your disposal?

A 'near-guarnteed' 8% return looks mighty attractive to me, but if that were my only 'egg', I could understand the concern about having all the eggs in one basket.

-gauss

[Brat]

8%? Have you considered that some of this is return of principal. Without really digging deep try taking your principal and dividing it by your actuarial remaining life span, deduct that from the annual distribution. Then take the distribution and divide it by your principal. If you are young you will want an inflation factor in an annuity.

[Animorph]

Yeah, it's not an 8% return, just an 8% payout. However, if your wife isn't 70 or so, it sounds like a good payout. The big catch is that it's worth $0 when your wife dies, so actual returns are harder to calculate.

Price some annuities and see if you can match the annuity reduction if you buy an SPIA with the lump sum.

Could you Roth convert some of the IRA before RMD's start? Sounds like that might be something that would be beneficial, even if current tax rates equal your RMD tax rates.

My bet for SS means testing would be income based, but then it can already be taxed.

[Running_Man]

ok i do not know where 8 percent is being calculated. You get $144,000 in exchange for a reduction of $12,980 of pension payments. This is 9 percent of the total cash and unless your wife is 70+ this is going to be nigh impossible to beat anywhere else. If you wife is 63 years old or older the entire pension should have backing of PBGC as well. without knowing the ages it is hard to say for certain but I am assuming she is under 65 and I think this is a very poor lump sum payout,

[pb4uski]

Check out immediateannuities.com and see if you bought a SPIA with the lump sum whether you could replicate the $1,080 reduction in monthly income. I suspect you'll find the lump sum is not a good deal.

Is the pension COLA'd?

[DoingHomework]

Thanks for the replies so far. They have been helpful in thinking about this. A few comments/answers:

My wife will be 55 at retirement. Actuarial life expectancy is about 34 years. She is in extremely good health and good family history. Given that, I was sloppy in treating the full difference as return instead of partly return of principle. If I roughly take out the return of principle I get a return of about 6%, not nearly as good. I had previously calculated the 8% by simply taking the extra $1080 times 12 and dividing by the lump sum. With exact numbers the answer was not exactly 8% but rounded to that.

The pension is not COLA'd but it does have a history of passing along periodic increases. These are at the whim of the legislature. We are not counting on them. Part of my thinking regarding the lump sum is that we could invest it to keep pace with inflation to produce our own modest COLA protection. Although they have done some things to make it more sound recently I suspect they will get very stingy with increases in the future.

immediateannuity.com shows a monthly payout of $630 rather than the $1080 with the pension (extra for foregoing the lump sum).

We have substantial other assets. We don't need the lump sum or the extra income. The attraction of the lump sum is that we will like have way more income than we need after RMDs kick in so shifting forward for flexibility is of interest.

But based on the comments and the new math of comparing to a SPIA. my new conclusion is that it is not a good idea.

Thanks for the help.

[Chuckanut]

Quote:

Originally Posted by DoingHomework The pension is not COLA'd <snip> Part of my thinking regarding the lump sum is that we could invest it to keep pace with inflation to produce our own modest COLA protection.

I know a number of people who have COLA'd their un COLA'd pension by investing a percent of it every month in a fund like Pssssst Wellesley or index funds. The earnings from this will, hopefully, help compensate them for inflation. Since these people are the ones who usually invested a percent of their earnings every month towards retirement, they were just continuing a good habit.

[pb4uski]

I would agree. Below are PVs at various interest rates and terms in years.

	Years
	14	24	34	44	54
10.5%	94,867	113,388	119,899	122,188	122,992
8.5%	105,891	132,502	143,910	148,801	150,897
6.5%	118,930	157,310	177,381	187,878	193,367
4.5%	134,433	189,999	225,459	248,089	262,530
2.5%	152,957	233,718	296,632	345,642	383,821

If she were to live to her actuarial life expectancy of 89 you would have to get a 8.5% annual return to break even with the $144k lump sum.

[Running_Man]

Quote:

Originally Posted by pb4uski I would agree. Below are PVs at various interest rates and terms in years. Years 14 24 34 44 54 10.5% 94,867 113,388 119,899 122,188 122,992 8.5% 105,891 132,502 143,910 148,801 150,897 6.5% 118,930 157,310 177,381 187,878 193,367 4.5% 134,433 189,999 225,459 248,089 262,530 2.5% 152,957 233,718 296,632 345,642 383,821 If she were to live to her actuarial life expectancy of 89 you would have to get a 8.5% annual return to break even with the $144k lump sum.

I think you are looking at this in reverse, isn't this saying you have to assume you can invest the stream of payments @ a 8.5% interest rate to get a net present value of $144,000 today? Apple just received 3.85% on their 30 yield, which would calculate a discount in the stream of $1080 monthly payments at that yield the stream of payments has a net present value of between $225,459 and $296,632 while he would be receiving only $144,000.

The employer is assuming the employee can invest the assets to return at @ 8.5% annual return. Most likely this is the implied return the pension plan is using.

With all the facts known, a monthly payment @ 55 with potential for at least partial COLA increases, taking the lump sum is a negative 80,000 minimum hit to the portfolio in a real world present value calculation.

[pb4uski]

What I'm saying is that if he took the $144k lump sum and invested it and took out $1,080 a month, that he would have to earn 8.5% on his investment account for his withdrawals to last the 34 years of his wife's remaining expected life and that I am skeptical that is realistic, so I think skipping the lump sum is the better alternative.

I think you might be looking at it in reverse. If he were to take the lump sum proceeds and invest and get 3.85%, he would need to get $225-$296k from the lump sum to avoid running out of money before the 34 years is up and they are only offering him $144k.

[Running_Man]

Quote:

Originally Posted by pb4uski What I'm saying is that if he took the $144k lump sum and invested it and took out $1,080 a month, that he would have to earn 8.5% on his investment account for his withdrawals to last the 34 years of his wife's remaining expected life and that I am skeptical that is realistic, so I think skipping the lump sum is the better alternative. I think you might be looking at it in reverse. If he were to take the lump sum proceeds and invest and get 3.85%, he would need to get $225-$296k from the lump sum to avoid running out of money before the 34 years is up and they are only offering him $144k.

No we are in agreement I was just misunderstanding your point, my bad

[brett]

I would take the pension for the reasons noted here.

I would always expect that an annuity would cost a little more than a commuted DB pension payout. For a start, the mortality ages for a DB pension group are lower that those of an annuity group. The DB plan statistically represents the population. The annuity group represents that proportion of the population who believe, or actually do, have a longer life span. Hence, those calculations must include longer projected life spans.

So, if you are in a DB plan, have good health, and a family history of longevity you are probably always better to take the pension.....assuming of course that you believe the company to be stable.