Purchase a COLA

[ERsoonihope]

Apologize if this has been covered elsewhere (but please point me to the thread if so).

Here's my situation; I am 61 YO, and have a non COLA pension of 42,000 annually. (DW has a 35,000 annual pension, with a 2.5% annual COLA adjustment.)

As a result of some litigation around my pension, I've been given an opportunity to choose between
A) adding a 1.5% annual COLA to the $42 K pension
B) taking a lump sum today of about $129 K.

I'm thinking B is the better choice, but to be honest, the math is making my eyes spin. I'm interested in what the smart folks on here have to say....

Outside of the pensions, have about $500 K invested (60/40) and will have Social Security benefits when we choose to file. We are optimists...meaning we plan on Social Security being there, and planning assumes we both live to 90.

Don't need the lump sum for anything today...so I'm really just trying to figure out what's the smart move on this new benefit. Am interested in any thoughts.

Thanks.

 

[Golden sunsets]

Others on this forum with more analytical minds will weigh in on the pension question, but my uninformed mind certainly leans toward taking the 1.5 cola on top of a $42,000 initial pension. Quite obviously the concern would be, will this pension be around in 5, 10 , 15 , etc. years from now? Your buy out now is approximately 3 times the annual value and is therefore a poor lump sum payout. The question becomes, what is the solvency of the pension?

 

[ERsoonihope]

Don't know for sure, of course, but I have a high level of confidence that the pension will be there for the long haul.

Just to be clear - the annual $42 K pension is fixed and will be there for life. The $129 K is simply to fund an addon 1.5% COLA... Or I can forgo the COLA and take the $129 K as a lump sum - in addition to the continuing pension.

 

[springnr]

A decent lump sum. I would go with B as it looks like your good without the cola, and can just let the lump grow. Also, I'm guessing your pension goes away if you do, the lump would still be there for your wife.

 

[RetireAge50]

The numbers do not seem right. Be sure your $42,000 pension does not go away if you take the lump sum.

 

[Senator]

If the choice is between (42K with a 1.5% COLA) OR [($42K pension No COLA) + $129K], I would take the $129K option, hands down.

1.5% of $42K is only $630. Your $129K would fund that for a lot longer than you will live.

 

[karluk]

I would lean towards taking the COLA over the lump sum, but (as you might guess) the better choice depends entirely on the assumptions you make about future investment returns and your own longevity.

Even though the COLA appears small compared with the lump sum, you have to keep in mind that it is an increasing compounded amount. You only have to make up a difference of $630 after the first COLA, but the difference between $42k and the COLA amount increases to $1,269.45 after the second adjustment, $1,918.49 after the third, and so forth.

According to my calculations, if you achieve a 5% return on the $129k lump sum, you will will be better off with the lump sum if you live 30 years or less, but better off with the COLA if you live longer than 30 years. The break even point with a 6% return is 35 years, and 44 years with a 7% return.

So, assuming there are no major errors in this calculation, you can make a serious case for either option. But this ignores obvious pitfalls like sequence of return risk, so I would probably take the COLA.

 

[pb4uski]

Don't know for sure, of course, but I have a high level of confidence that the pension will be there for the long haul.

Just to be clear - the annual $42 K pension is fixed and will be there for life. The $129 K is simply to fund an addon 1.5% COLA... Or I can forgo the COLA and take the $129 K as a lump sum - in addition to the continuing pension.

I look at it as if you are "investing" (foregoing receiving) $129k today and then receiving additional benefits of $630 in year 1, $1,269 in year 2, $1,918 in year 3... $6,742 in year 10... $10,510 in year 15.... $14,568 in year 20... $18,940 in year 25 ... $23,650 in year 30... The benefits are solely the COLA amounts based on $42k a year inflated at 1.5%.

The internal rate of return between the $129k lump sum and the benefits for 30 years is 5.1%. In other words, if you can invest the lump sum and earn 5.1% or more, the lump sum could fully fund the 1.5% COLA benefits.

Given the historical rate of return for a balanced portfolio is substantially greater than 5.1%, I would favor the lump sum.

Edited to add: I had not seen karluk's post and we are analyzing the problem the same way but coming to different conclusions - go figure!!! I focus only on the 30 year and ignore the 35 and 44 years because the OP is already 61 and 30 years would take him to 91.

YMMV

 

[Cobra9777]

My quick spreadsheet produced results very similar to karluk and pb4uski. Through age 90 (OP's planning assumption), the PV of the COLA payments is $129K at about 5%... which makes it a bit of a toss-up in my mind. However, the COLA option is much less attractive at -say- age 83.

So as karluk said, it really boils down to your realistic assumptions about investment returns and longevity. Historically, your 60/40 portfolio returned 8.9%, which would favor the lump sum option. But I'm generally not that optimistic going forward considering interest rates are at zero. My personal planning assumption is below 5%.

One other consideration is taxes. Your two pensions total $77K. With dividends, deductions, and exemptions, you probably land just below the top of 15% bracket. Plus SS coming at some point. If you take the lump sum and fold it into the 60/40 portfolio, it might help keep your qualified dividends and CGs at 0%. You'd have to do the math to see how that plays out over time. And, given the size of your portfolio, it's likely to be far less significant to the decision than your assumptions about longevity and investment returns.

Everything considered, I'd probably go with the lump sum. But neither choice is a clear winner.

 

[RetireAge50]

I was surprised when I plugged in the numbers and came up with the 5% return over 30 years. So maybe the numbers/offer is legit.

Nevertheless I would definitely take the lump sum as IRR is negative or very low until very late in your life.

Sequence of returns should not be an issue as you stated the money is not really needed. Putting the lump sum into a Wellington/Wellesley type fund will likely far outperform the COLA.

Also the lump sum will be available throughout your life and longer.


Sent from my iPhone using Early Retirement Forum

 

[Chuckanut]

I imagine there are segeral scenarios depending upon your life expectancy, taxes, survivor benefits, etc. This is a lot of money. Why not take the facts and figures to a CPA, pay him or her for an hour of time, and get some options in present value dollars?

There's also a personal issue of how one manages money. For example, if one would be tempted to blow the lump sum on a new car, 5 star hotels in swinging hot spots, and $50 bottles of wine with $150 dinners out, then taking the COLA might be more prudent.

Overall, this is a nice problem to have. Congratulations!

 

[savory]

I think Karluk & pb4uski provided a great analysis. While I was a pension guy vs. lump sum when I had to make that choice, given where I am at today with pension and SS covering most of my needs, I would opt for the lump sum. While I would likely still be conservative with spending it, just in case I need it in the future, I would still use some of it for fun.

 

[sengsational]

Usually when these kinds of offers are made, they're constructed so that the company making the offer doesn't care which one you choose.

In other words, they've already done the math. Or if you took the $129K and bought a COLA annuity, that, plus the non-cola annuity would result in the same cash flow (less overhead and commissions, I suppose).

If I had the choice, I'd concentrate on how taxes would play into it. Taking a lump sum will get hit hard at first, but gives you the flexibility to get under some tax brackets or subsidy levels, in the future. Taking the COLA means that extra $ is going to show as income, and you have no control over that.

True, having the lump sum will allow you to, statistically speaking, get a larger return by putting it in the equity market. But since you have a half million split 60/40, you could take the COLA option, then increase your equity allocation and achieve the same equity allocation as you would have if you took the $129 and put it in equities.

 

[springnr]

The lump sum is pension funds, should roll right into an IRA without being taxed?

 

[pb4uski]

....If I had the choice, I'd concentrate on how taxes would play into it. Taking a lump sum will get hit hard at first...

The lump sum is pension funds, should roll right into an IRA without being taxed?

Yes, if I was the OP I would check with the pension administrator but I would think that like any lump sum the qualified money could be rolled into a tIRA with no current tax consequences so there would not be any upfront tax cost.

 

[ERsoonihope]

Thanks all - really appreciate the analysis, and the different perspectives. The 30 year time frame sort of matches up with what I was estimating... but it helps a ton to hear it from people who can calculate an IRR with confidence!

The $129 K can roll over into an IRA. I think I am leaning toward taking that route - reasoning is that we have a pretty good income with the pensions now, and when Social Security kicks in, we'll be bringing in more than we're spending (at least until inflation catches up with us). And when inflation does catch up with our pension plus SSA money, we'll likely be in better shape to handle it if we've invested this money.

I'm pretty confident we won't blow it...we tend to take money like this, throw it into the investment bucket, and then ignore it until needed.

Thanks for the responses.