Personal Finance: Lump Sum Or Monthly Annuity?

At some point in your life — especially as you get closer to retirement — you may be presented with the following option: Accept a pension payout for a job you held previously, begin taking a monthly payout immediately, or take a monthly payout later.

The decision you make can have huge implications on your retirement years. Today, I walk you through some considerations using a real example.

Case Study

I have worked for several companies during my career. Some of these companies offered pension plans, some offered 401K accounts, and some offered both.

For those that offered 401Ks, once I left the job I was allowed to roll that 401K over into another retirement account. Today, I won’t address the decision-making process that goes into a 401K rollover.

What I do want to address is when a company offers a lump sum in lieu of a monthly annuity payment.

One of my employers for a few years recently sent me the following option. I could take 1). A lump sump payout from my pension of $55,007.02; 2). A monthly lifetime annuity beginning immediately of $266.89; 3). A monthly annuity that would transfer to my wife for the rest of her life if she outlives me of $243.72; or 4). A monthly lifetime annuity of $600 if I wait until I am 65 (12+ more years) to begin taking payments.

You may face a similar choice at some point. The amounts will differ, but the logic behind the decision should be similar. Unless you do the math, you can’t make an educated decision. (You may face a similar decision trying to determine whether to start taking Social Security payments early.)

Here are the considerations. If I accept the lump sum, I can put it into an income-producing vehicle and generate my own income. I will delve more into that below.

I will ignore tax considerations, except to say if you aren’t at retirement age and you don’t roll that lump sum into a retirement account, you will owe income taxes and penalties on the total. Be sure to roll it over into an appropriate retirement account.

If I accept any combination of the monthly annuity, at the end of my life (or my wife’s) that monthly payment will end, and there won’t be anything left.

For example, if I take the lifetime annuity for just myself, by the age of 80 — the approximate lifespan of a male in the U.S. — I will have received $86,739 if I start taking payments immediately. If I delay payments until I am 65, by the time I am 80 I will have received $108,600. The longer I live, the more I will ultimately be paid. Sounds like a pretty good deal, especially if I live a long life.

But here’s what the choice really comes down to. If I took the lump sum, what rate of return would I need to generate $266.89 a month of income (the monthly amount of the annuity)? That is equivalent to $3,202.68 per year, which is 5.8% of $55,007.02.

In other words, if I can earn 5.8% per year on the lump sum, I will generate the equivalent monthly income that I would if I accepted the monthly annuity. At the same time, I would be preserving that lump sum. With the annuities, when the payments stop, there is nothing left.

Let’s consider an intermediate case. Let’s say I earn 3% annually on that lump sum. That would be $1650.21 in the first year. Now, let’s say I want to maintain the previous annual income of $3,202.68 by withdrawing the return plus part of the principal. In this case, the principal will go down every year as I supplement the return.

This is a more complex situation, but it’s essentially the inverse of a mortgage calculation. The $55,000 monthly annuity would reach a zero balance just after my 77th birthday. I would have been paid a total of $77,655. In fact, I ran one more case to see how high my return must be for the lump sum to last until my 80th birthday. That happens to be 3.6%.

Consequently, 3.6% is an important number. If I can earn a higher average annual return than this, by my 80th birthday I will be better off taking the lump sum. If I am not confident that I can, then I am better off taking annuity payments. But it also tells me that it would be a mistake in the long run to take the lump sum and invest in any fixed income choice paying less than 3.6%.

There are risks and considerations either way. If I didn’t think I would live very long, the lump sum makes the most sense. If I think I would live a long life, the lump sum makes the most sense if the returns are high enough. What constitutes “high enough” would depend on how long I live — an unknown variable.

If I could use the lump sum to buy U.S. Treasury Bonds that yield 4%, my decision would be a no-brainer. The downside risk would be near zero. I would immediately receive the $55,000, so if something happened to me in the short-term, my beneficiaries would still get the money. In the longer term, a safe 4% return would allow me to withdraw $3,202.68 monthly until past my 82nd birthday.

But there aren’t any risk-free investments that yield 4% or better. I must balance risk and reward. This depends on how much I will depend on the income. In my case, I can afford to take a bit more risk. However, I also don’t want to put all my eggs in one basket.

There are investment vehicles that pay yields in the 6% to 8% range. For example, one of my favorite master limited partnerships (MLPs) is Enviva Partners LP (NYSE: EVA). The company makes wood pellets primarily for the European market. EVA yields 8.2%, which would generate 41% more income than the annuity payout.

But if for some unforeseen reason the company went bankrupt, there goes my pension. I can’t risk that.

My Decision

Since this income isn’t critical to my retirement, I decided I could accept a bit more risk. But I wanted a managed fund, to make sure that risks were being managed as the business cycle changes.

I selected the Vanguard LifeStrategy Growth Fund (VASGX). I like Vanguard funds because their expenses are extremely low. This particular fund consists of 20% bonds, about 50% domestic stocks, and about 30% international stocks. Since its 1994 inception, the fund has returned an annual average of 8.03%. Over the past 10 years, the annual average return was 10.51%.

Of course, past performance is no guarantee of future performance, but 8.03% would enable me to have more income from the lump sum over time, and/or grow it into a larger sum. If I didn’t withdraw anything and returned 8% per year, in 12 years (when I turn 65) the $55,007.02 lump sum will have grown to $144,000.

I am accepting a downside risk that could see this fund pull back by 20%-30% in a bear market. If you are depending on this income for your retirement — especially if you will need it within the next five years — then under no circumstances should you risk this much downside. If that is your situation, find yourself a fund with a greater percentage of bonds, which would reduce your downside risk.

In any case, when presented with this sort of option, be sure to do the math. Or consult with a financial adviser who can help. Otherwise, you risk costing yourself a lot of money over time.

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