Wednesday, February 25, 2015

Buying an Annuity with Some of Your Accumulated Savings—What is the Best Approach to Bolster Your Spending Budget?

This post is an update of my post of September 22, 2013 where I discussed some of the benefits of managing retirement risks by diversifying sources of retirement income.  Today, I will look at the effect on a hypothetical retiree’s budget of several annuity purchase strategies based on annuity purchase rates obtained from
Let’s assume, Mike, our hypothetical single male retiree, is age 65.  He has recently retired with a 401(k) balance of $750,000.  Mike is eligible for an immediate (reduced) Social Security benefit of $1,400 per month ($16,800 per year).  He has no other retirement assets or sources of income. 

Base Spending Budget

Mike uses the “Excluding Social Security” spreadsheet on this website and the recommended assumptions with no amount to be left to heirs to develop a base budget for 2015 of $49,427 ($16,800 from Social Security plus $32,627 from accumulated savings).

Mike is not pleased with this spending budget.  He would like his spending budget to be higher.  He knows that he can use more aggressive assumptions (higher real rates of return or lower expected payout period) or he can plan on a budget that declines in real dollar terms as he ages.  Before looking at these options, he decides to look at what effect several alternative annuity purchase strategies might have on his base budget.  

Strategy #1--Defer Social Security to Age 70

I know I said that I was going to look at several annuity purchase strategies.  So why am I starting with this option?  Because under this approach, Mike would essentially be buying a deferred annuity from Social Security.  And while this deferred annuity deal is generally more favorable for a married worker with a spouse who hasn’t worked in covered employment (because of the joint and survivor nature of such annuity), it is still favorable for Mike because it provides both longevity and inflation protection.   

Mike goes to the “Social Security Bridge” spreadsheet on this website.  If he defers commencement of his Social Security benefit to age 70, it will increase to $1,980 per month before inflation increases and $2,240 after assumed increases of 2.5% per year (or $26,882 per year at age 70).  The spreadsheet tells him that his 2015 spending budget would be $51,412 if he decided to defer commencement of Social Security to age 70 and made no other changes.  If he goes to the “Run-out” section of the spreadsheet, he sees that if all assumptions are accurate, he will spend a total of $124,890 of his accumulated savings to “purchase” the extra annuity from Social Security.  At a 4.5% discount rate, this is equivalent to a single premium of $114,329 payable at age 65.

Another way for Mike to check this result is to go to the Excluding Social Security spreadsheet and pretend that he has $635,671 ($750,000 - $114,329) in assets and a Social Security benefit payable at age 65 of $23,758 rather than $16,800 as in the base budget situation.  Thus, Mike sees that if he spends $114,329 of his assets, he is “effectively” able to purchase an additional $6,958 ($23,758 - $16,800) of Social Security benefit starting at age 65.  But his total 2015 spending budget is only increased by $1,985 ($51,412 - $49,427) as result of his decision to defer.  Mike is somewhat disappointed with this as he has been reading in all the business/personal finance websites that deferring commencement of Social Security is by far the smartest action for a retiree to take.  As discussed above, however, Mike is single and deferring Social Security is generally not quite as good of deal for single workers as for married couples with one primary wage earner. 

Strategy #2--Defer Social Security and Buy an Immediate Annuity

Mike wonders if he can increase his spending budget by purchasing an immediate life annuity in addition to deferring his Social Security benefit.  He goes to and sees that he can purchase $8,250 of annual income payable for his life for $125,000.   If he subtracts $125,000 from the net assets he has after subtracting the present value of the Social Security “bridge” payments, he would have $510,671 remaining.  He enters that amount in accumulated savings and $8,250 as the life annuity amount in the Excluding Social Security spreadsheet.  The resulting 2015 budget under this scenario is $52,332 ($23,758 from accumulated savings as the bridge payment plus $8,250 from the annuity plus an additional $20,324 from accumulated savings). 

Strategy #3--Defer Social Security and Buy a Deferred Annuity (QLAC)

Being familiar with my website, Mike has heard me tout the virtues of Qualified Longevity Annuity Contracts.  They provide a purer form of longevity insurance than immediate annuities.  So, Mike goes to and looks to see how much income he can buy for $125,000 with an annuity starting age of 85 and no pre-commencement death benefits.  He sees that he can buy $47,035 per annum starting at age 85.  He enters that amount and 20 years deferral in the Excluding Social Security spreadsheet together with accumulated assets of $510,671 and the spreadsheet gives him a budget of $53,875 ($23,758 from accumulated savings as the bridge payment plus an additional $30,117 in accumulated savings).  This budget is almost 9% higher than his base spending budget.

What does Mike do?  

First, Mike notices that he seems to get more “bang for the buck” from a QLAC purchase than from an equal-cost immediate annuity purchase in terms of increasing his spending budget.  But, Mike is bothered by the fact that he won’t get any return on this investment if he dies prior to age 85.  Mike decides that he will defer commencement of his Social Security benefit (at least for one year), but he decides that the QLAC annuity market is still not robust enough (and he feels interest rates are just too low) to make the purchase at this time.  He will look at the trend of annuity purchase rates during the next twelve months and revisit the issue again next year. 

Wednesday, February 18, 2015

Crunching the Numbers on that Lump Sum Buyout Offer (Or Lump Sum Optional Form of Payment)

In light of ever-increasing flat dollar premiums charged by the Pension Benefit Guaranty Corporation, changes in the IRS mortality tables used to determine minimum lump sum values scheduled for 2016  and other reasons, more defined benefit plan sponsors are likely to settle some or all of their pension plan liabilities in 2015.  Settlement of pension liabilities generally involves transfer of the liability to an insurance company (through annuity purchase), lump sum window offers to participants or a combination of the two approaches.  This post will provide a process that retirees can use to evaluate some of the financial implications associated with a lump sum buyout option and will illustrate the process with an example.  Note that the recommended “number crunching” that follows applies equally to a pension plan participant who is retiring (or near retirement) and is being given an option to take a lump sum in lieu of a lifetime income form of payment.

Many articles have been written about the pros and cons of taking lumps sums in lieu of promised pension annuity payments.   Even though pension plan participants have been choosing between lifetime income and lump sums for years, this issue gathered significant media attention several years ago when both GM and Ford opened lump sum buyout windows to some of their plan participants who had already retired.   The Pension Rights Center has a web page with several articles generally encouraging retirees to reject the lump sum option. 

In general, I agree with the experts who encourage retirees to stay with the annuity (payable either from an insurance company or from the plan) rather than take the lump sum.  The advantages of doing so are clearly set forth in the Pension Rights Center material (and elsewhere).   But, interest rates to determine lump sums are currently very low, and retirees may be legitimately tempted by the amount of the lump sum offer they may be eligible to receive and roll over to an IRA.  As a retired actuary, I am always interested in crunching numbers before I make important decisions.  If you receive a lump sum buyout offer, I encourage you to get some annuity quotes and use the Excluding Social Security spreadsheet on this website to give yourself some additional financial “data points” so that you can properly make your decision. 

To illustrate the approach I would use, let’s assume we have a single male 65 year old retiree named Rick with accumulated savings of $500,000, a $24,000 annual pension and an annual Social Security benefit of $20,000.   Rick used the spreadsheet on this website and the newly revised assumptions to develop a spending budget for 2015 (assuming zero bequest motive) of $59,523 ($15,523 from savings, $24,000 from pension and $20,000 from Social Security).   Shortly thereafter, Rick receives a lump sum buyout offer of $327,200 in lieu of his life annuity payment of $24,000 per year.  What should he do?

Recalculate Spending Budget

The first thing Rick does is go back to the spreadsheet to see what the impact would be on his 2015 spending budget if he had an additional $327,200 in accumulated savings (by taking the lump sum and rolling it over to his IRA) but no pension income.   Under the recommended assumptions, these changes would produce a $55,985 spending budget ($35,985 from accumulated savings plus $20,000 from Social Security).  Rick then plays around with the spreadsheet to determine what additional investment return he would have to earn on the lump sum amount or decreased payment period would make up for the $3,538 decrease in his spending budget.  He determines that he would have to earn an additional 2% real rate of return (or approximately a 4% real annual rate of return) on the lump sum or reduce his expected payout period with respect to the lump sum by about 8 years.

Determine Cost of Immediate Annuity

The next thing Rick does is see how this lump sum offer compares with approximately how much it would cost to purchase an annuity that provides the same level of benefit as his pension.   He goes to and (as of February 18, 2015) determines that the approximate purchase price of an annuity providing $2,000 per month for him commencing next month is about $363,600 (he lives in California), or about 11% higher than the lump sum offer.  If he were serious about buying an annuity with the lump sum (or if his pension annuity were not a single life annuity), he would need to obtain an actual quote.   However, the information from this website is  reasonably sufficient to tell Rick that the lump sum offer is probably less than the market value (or purchase price) of his pension annuity.  Note that if Rick were a female, the quote is currently about 20% higher than the $327,200 lump sum offer.  Since pension plan lump sum offers are based on unisex mortality assumptions (and will therefore be equal in amount for males and females of the same age with the same benefits) and annuity rates from insurance companies are higher for females than males, a pension lump sum offer will almost always be more favorable for males than females when measured as a percentage of the market value of the annuity.  

Determine Cost of Deferred Annuity and Consider Partial Annuity/Partial Self Investment Approach

By looking at approximate immediate annuity costs, Rick has determined that he probably cannot take the lump sum, roll it over to an IRA and buy an immediate annuity that replaces the benefit provided by his pension.  This is not terribly surprising since if an immediate annuity could be purchased for less than the lump sum cost, the plan sponsor could simply settle Rick’s pension liability at less expense by purchasing the annuity itself.     Rick wonders, however, if he can elect the lump sum, roll it over to an IRA, buy a deferred annuity (also referred to as a longevity annuity or QLAC), with a portion of the lump sum and invest the remainder of the lump sum and come out ahead.  He goes back to the immediateannuity website and enters “20” years for commencement of the $2,000 per month annuity.   As of February 18, the amount shown to purchase this deferred annuity is $63,776.  So he can spend $63,776 to replace the pension annuity payments he would have received from his pension starting at age 85 and invest the remaining $263,424 ($327,200 minus $63,776).  He goes back to the “Excluding Social Security” spreadsheet and enters $763,424 in accumulated savings, $0 immediate annuity, $24,000 deferred annuity and a 20 year deferral period.  Under this scenario (and recommended assumptions), his 2015 spending budget would be $57,243 ($37,243 from accumulated savings plus $20,000 from Social Security).  This budget amount is more than the budget determined above with no annuity income, but less than the original 2015 budget with his pension.  Rick can play around with the assumptions in the spreadsheet to see what real interest rate or expected payout period would close the gap.  Again, if Rick were serious about pursuing this route, he would probably get an actual annuity quote.  

Based on his thorough analysis which included the calculations above, Rick decided to keep his pension annuity.  Your decision may be different based on your analysis and the amount of the lump sum you are offered.  But, as always, if you are doing this analysis on your own, I encourage you to crunch your numbers and think about the three major assumptions (investment return, inflation and longevity) used in the calculations.  A decision with respect to a lump sum offer could be one of the most important financial decisions you make in retirement.

Saturday, February 14, 2015

Recommended Assumptions for 2015—Part II

Since our post of October 11, 2013, we have been recommending use of a 5% investment return assumption and a 3% inflation assumption when using the simple spreadsheets on our website to develop a spending budget.  These recommended assumptions were loosely tied to estimated assumptions “baked into” an annuity purchase rate of approximately $600 per month for a single premium of $100,000 (or $167 per each $1 of monthly income) for a 65-year old male obtained from the website back in the Fall of 2013.

Annuity purchase rates have become more expensive since October 11, 2013.  In our post of December 3, 2014, we recommended staying with the 5% investment return and 3% inflation assumptions for 2015 budget determinations even though the annuity purchase rate for a 65-year old male had increased to $571 per month per $100,000 of premium (or $175 per each $1 of monthly income).  As of February 5, 2015, however, the monthly annuity purchase rate for a 65-year old male per $100,000 had increased to $549 (or $182 per each dollar of monthly income).  To maintain a more comparable relationship between investment in annuities and investment in other securities, we now recommend using a 4.5% investment return assumption and a 2.5% inflation assumption for budget determinations.   We continue to recommend an expected payout period equal to 95 minus current age, or life expectancy if greater. 

This change in recommended assumptions should have very little impact on budget determinations for retirees with little or no fixed income annuity/pension income.   It will, however, have a more significant impact for those with significant amounts of fixed income annuity/pension income or for those who are considering purchasing an annuity with some of their accumulated savings.

Wednesday, February 4, 2015

Don’t Focus on a Single Assumption When Determining Your Annual Withdrawal--All Three Matter

In his recent article, "How Retirement Plans Vastly Underestimate Inflation",  Henry (Bud) Hebeler , states, "Almost every retirement planner has a default inflation rate of 3%. That can be a terrible mistake."  He goes on to say, "[assuming 3% inflation is] just plain wrong considering post-World War II results as well as the way the Feds have been printing money and current jittery foreign economics. I personally believe that it would be a lot better if people used something like 4.5% which is a little more conservative than the post-World War II average."
I appreciate the passion expressed by Bud in his article, but as one who currently recommends a 3% inflation assumption, I feel obligated to push back on Bud on this one. 

Readers of this site will know that the annual withdrawal rate determined under the Actuarial Approach, or most any other reasonable dynamic withdrawal approach is a function of three assumptions: (1) future asset investment return,  (2) future inflation and (3) future longevity.  To focus on one assumption while ignoring the other two, as Bud has done, is a fools game.  I'm not going to argue with Bud about the wisdom of using historical inflation averages to project future experience in this different environment.  He may be right,  but that it not the point. 

Yes, it is more conservative to assume higher levels of future inflation, all other things being equal, but higher assumed levels of inflation combined with even higher levels of assumed investment return and/or shorter life expectancies can produce withdrawal rates that are more aggressive (higher) than assumption combinations that involve lower assumed rates of inflation.  If there are no other fixed income annuity/pension sources of income that need to be coordinated within the spending budget, it is generally sufficient to focus on real (after-inflation) levels of investment return, not nominal levels.  In these situations, what should matter most to a retiree is the level of withdrawal produced by the combination of assumptions, not whether one of the three assumptions appears to be somewhat out of line with historical experience.

I am also a little surprised to see Bud fanning the inflation fires so quickly after writing his article of January 16, 2015  (discussed in our January 22 post), where he recommended withdrawals based on a 5% investment return, 3.5% inflation and IRS Publication 590 life expectancies.  This combination of assumptions produced a 5.5% withdrawal rate for a 65-year retiree compared with the 4.3% withdrawal rate under the Actuarial Approach using the recommended combination of assumptions. 

There is one summary statistic that a retiree can look at to obtain a measure of how conservative or aggressive her assumptions are in combination--the withdrawal rate for the current year produced by her withdrawal strategy (the amount to be withdrawn from accumulated savings divided by the beginning of year accumulated savings).  The following table shows withdrawal rates produced by the Actuarial Approach under the 2015 recommended combination of assumptions at various ages (assuming no coordination with other fixed annuity/pension income and no bequest motive).  Withdrawal rates at the indicated ages that are higher than those shown in the table are based on assumptions that are more aggressive in combination than the 2015 recommended assumptions.  Withdrawal rates at the indicated ages that are lower than those shown in the table are more conservative in combination, all things being equal.

Having said the above, I will concede that if a retiree is developing a spending budget that involves coordinating significant amounts of fixed income annuity/pension income or  real dollar bequest motive into her budget, the nominal accuracy (and not just the real relationship) of  the assumptions for investment return and inflation can be important.