Monday, August 4, 2014

Lump Sum or Monthly Pension Checks?

I had a short conversation with one of the engineers I used to work with.

He asked whether I had opted for the Lump Sum payout or the Monthly Pension Checks.  He is contemplating retirement and was surveying some retirees. 

I was flattered that he asked.  This guy is an engineer's engineer.  Ask him a technical question and, from memory, he will spin a Micheneresque tale starting with dust cooling and coalescing in the cosmos, then the tectonic movements that resulted in the distribution of commercially exploitable manganese and chromium ores, the political trajectories of the Belgium Congo and former Soviet republics, then discuss methods historically used by the Swiss to the heat-treat hair springs used in the mechanical movements of wrist watches and conclude with the impact of infrared sensing and programmable controllers on the heat-treatment of medium carbon steel.  Of course, by this time you forgot the original question.

The short answer

You don't need the lump sum if you practiced discipline during your working years, lived below your means and saved money.  You have some money to play with as opportunities...or emergencies...pop up.

You cannot be trusted with a lump sum if you never had the discipline to save during your working years.  By what miracle do you expect self-discipline to appear when you were unable to conjure it up in your previous 40 years of working?

Bottom line, you don't need to take the lump sum if you saved money and you shouldn't take the lump sum if you did not save money.

The slightly longer answer

Take an  honest look at your life expectancy.  The engineer in question is about 5' 10" tall, weighs 160 pounds, has a cholesterol reading of 145 and can rip off 60 pushups before his arms get tired.  Both of his parents are still alive.

Because monthly checks (annuities) set the amount based on the life expectancies of large pools of people they are able to budget a larger monthly amount.  The retiree who dies before receiving their first check frees up funds to pay those retirees who live into their nineties.  Every retiree who takes a lump sum must budget as if they (and their spouse) will live into their nineties.  That means they must be more protective of their capital. 

For example, a typical rule of thumb is to only withdraw 4% of your savings every year.  That is $3.33 a month for every thousand dollars you have saved.  Annuities, at least those with low fees and overhead, can pay more than that.

If, however, you or your spouse have major health issues and there is a reasonable expectation that one of you will die within five years of retiring....then the lump sum is probably a smart move.

Another time to consider a lump sum is if it is important to leave a significant estate to your children.  In the annuitity, the funds that were ear-marked for you roll over when you die and pay for your peers who were lucky enough to outlive you.  Those funds do not go to your heirs.

Secondary considerations

In theory, the funds you have in a 401-k or an IRA are fire-walled off from settlements in civil suites.  I suspect there is pressure to consider those funds as "net assets" when settlements are awarded because there are mechanisms to liquidate them.  "Pensions" are not as subject to those pressures because they are harder to quantify as a net asset.  Right or wrong there is also a cultural dimension to the Pension/assets issue. 

People who are fearful of inflation will favor the lump sum.  "Give me my money before the value erodes down to nothing."

It might not matter

If you are lucky enough to have a defined benefit pension the holder of that pension still has the ability to terminate that plan if/when the administrate costs become burdensome and force you to take a lump sum.  Three things have slowed down plan termination.

Law prohibits lump sum payouts if the fund is less than 80% funded.  The effect of paying out lump sums pulls capital out of the plan and lowers the funding level for those who remain if the fund is less than 100% capitalized.  Very good read HERE.

Low interest rates increase the net present value of the annuity and force the companies to pay out larger lump sums.  The Fed's attempts to reinflate the economy resulted in historically low interest rates.

Blow-back from current employees who have defined benefit plans.  This factor becomes more minor as fewer and fewer employees are offered pensions as part of their benefit package.


  1. Good precis, first time I've heard below 4% on the withdrawls though... Before I always heard 4-4.5%...

  2. Hello Old NFO

    That was not a very well written or punctuated posts. The $3.33 per thousand dollars is a per month value. It is the same number everybody uses, 4% a year. I used "per month" because that is how Mrs ERJ and I budget.

    Another thing that does not get discussed is how frequently that $3.33/$1000 (or 4%) number get recalculated. I had always assumed it was an annual calculation...probably done the same time one rebalanced their asset allocation.

    A careful re-reading of some of the financial writers implied that it was a one-time calculation. That is, make the calculation and then tell Fidelity, Vanguard or whoever to mail you a check for $x into infinity.

    If that is the basis for the simulations then extra conservatism must be baked into that 4% number. If one has comfort with the amount varying year-by-year than one can undoubtedly pick a higher percentage....just don't forget to reset the number.

    One compelling case for the higher percentage and annual recalculations is that many retired people have the health and inclination to work their bucket list down. That takes funds. Then, as they get older and their most urgent desires are fulfilled, they (supposedly) like to stay home and watch the hummingbirds which is less cash intensive. The higher %/Recalc would front load more of the cash withdraw unless the markets over-perform.

    Like any casino, you walk up to the roulette wheel, make your choices and put your money down. Nobody can guarantee anything except that "the house" is taking a skim.


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