There are many good reasons why you might want to elect a lump sum distribution from a pension plan (and roll it over to an IRA), including:
- Potentially greater investment returns
- Potentially larger amounts to pass along to heirs
- More flexible spending
- Potentially greater inflation protection
- You (or your spouse) expect to have a shorter lifetime than assumed in the lump sum calculation.
For a retiree, or someone close to retirement, the decision to take a lump sum or a life annuity form of payment from a pension plan is a classic example of what we have been talking about in our last few posts--the decision of how much of one’s assets should be allocated to the less-risky floor portfolio to fund essential expenses and how much should be allocated to the more-risky upside portfolio to fund non-essential expenses. As discussed in our prior posts, we encourage you to use our ABC workbooks to help you make this decision. As we generally do, we will use an example in this post to illustrate the calculations you may wish to perform if you (or your spouse) are offered a lump sum option under a pension plan.
Before we jump into the example, we have a few comments on the lump sum/annuity decision to supplement Elizabeth Bauers’, article:
In our experience, the minimum lump sum amount determined under IRS rules is generally less than the amount required to purchase the same immediate lifetime annuity amount in the retail insurance market. The lump sum amount may be relatively close to the annuity cost for male participants, but it is generally not as close for female participants. Since IRS lump sums are determined using unisex mortality, and life annuities offered by insurance companies are generally more expensive for females than males, this means that lump sum offers for females will usually be even less attractive than for males in terms of being able replace the same amount of immediate income via an annuity purchase with the rolled over distribution (and therefore, less attractive in general).
As discussed above, there are several good reasons why an individual or couple may decide to elect the lump sum option and roll it over despite the fact that the proceeds may be insufficient to purchase the same amount of lifetime annuity in the retail annuity market. The individual may believe that he or she already has a sufficiently large floor portfolio or simply desires to have a larger upside portfolio.
As discussed in our post of February 18, 2015, the lump sum election does not necessarily need to be a black and white choice between more risky investments and guaranteed lifetime investments. Another option that may be considered is to roll-over the lump sum distribution to an IRA and use a portion of such roll-over to purchase a deferred annuity (or Qualified Longevity Annuity Contract, or QLAC) with the remainder of the roll-over invested in more risky assets. Under this approach, it may be possible to achieve the desired balance between floor and upside portfolios.
We are not investment advisors. And, as retired actuaries, we tend to be pretty conservative. With the Shiller PE Ratio hovering above 30, the length of time since the most recent significant recession increasing, and our luck, we would be worried about the stock market tanking shortly after we elected a lump sum, rolled-over the distribution into an IRA and invested significant amounts of the proceeds in equities. But you never know. After we wrote our original post on lump sums elections in 2015, we heard from several readers who said they did quite well for themselves after taking their lump sums, thank you.
While we believe that the Actuarial Approach utilizing our default deterministic assumptions is superior to Monte Carlo modeling for developing a reasonable spending budget in retirement, we acknowledge that reasonable Monte Carlo models utilizing stochastic assumptions can be superior to the Actuarial Approach for developing probabilities associated with alternative investment approaches. Therefore, you may wish to consult a financial advisor to help you with your lump sum option decision.
Example
In this post, we will look at Bill and Brenda’s financial situation. They are both age 65 and, as in several of our recent posts, for calculation simplicity, they are assumed to have established separate funding sources to take care of unexpected expenses, nonrecurring expenses, long-term care costs and amounts desired to be left to heirs. Bill is receiving $22,000 per annum from Social Security and $8,000 per annum from his pension (payable for his life in a fixed amount each year). Brenda is receiving $18,000 per annum from Social Security and $13,000 per annum payable for her life from her pension plan. They have accumulated savings of $300,000.
We are going to use the same monthly annuity purchase rates per $100,000 for a 65-year old male from Immediateannuities.com as used in our last post for this example.
Bill has received a limited time offer to elect to receive a lump-sum payment in lieu of his $8,000 per annum pension benefit. We are going to assume that the lump-sum offer, using minimum IRS assumptions is $113,139 or about 93% of the cost of buying his annual $8,000 life annuity using the annuity purchase rate above ($121,655). We are also going to assume that Bill and Brenda have estimated their essential annual recurring expenses are $50,000. Going to our ABC for retired couples, entering default assumptions and a 33% desired decrease in spending budget upon the first death within the couple, they determine that the present value of their estimated future essential expenses is about $1,208,600 ($50,000 X the present value of future years with desired increases and desired decrease on death factor from the workbook of 24.1720).
They determine their current annual recurring expenses and “floor portfolios” under three options:
- Option #1—reject the lump sum offer
- Option #2—accept the lump sum offer, roll-over and invest the distribution in more risky assets
- Option #3—accept the lump sum offer, roll-over the distribution and invest $40,000 of the proceeds in a deferred annuity/QLAC for Bill with payments starting at age 85 and no death benefits if he dies prior to age 85
The table below summarizes the results of Bill and Brenda’s calculations under the three options described above.
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The first thing that Bill and Brenda notice by looking at Option 2 is that under the default longevity assumptions used in the Actuarial Budget Calculator (primarily that Bill is expected to live to 94), not only is Bill’s lump sum offer less than the amount necessary for him to buy his $8,000 in the current annuity market ($121,655), but it is also much less than the present value of his pension under the default assumptions. The second thing that they notice is that taking the lump sum offer would get them $113,139 more in assets to invest, but it would decrease their recurring spending budget by about 2% and drop their floor portfolio below their desired target to fund essential expenses of $1,208,600.
Under Option 3, their annual recurring spending budget is slightly lower than under Option 1, but this option increases the amount they can invest in more risky assets by $73,139 and they can still hit their desired floor portfolio. On the other hand, they have increased the risk somewhat that their essential spending will fall below $50,000 in real dollars prior to the time Bill’s QLAC is scheduled to commence (cash-flow risk associated with QLACs as discussed in our previous post).
Conclusion
If you are lucky enough to currently be receiving one or more pension benefits, it may be worth your while to consider a limited period lump sum offer. You should note that if you are currently receiving a pension benefit, the decision to offer a limited period lump sum window is at your former employer’s discretion. It is not something you can demand. On the other hand, if you have not yet retired or terminated employment and your defined benefit plan offers a lump sum option, you must be offered a life annuity option upon termination of employment. In either event, your spouse must consent if you elect the lump sum option (or any form of payment other than as a qualified joint and survivor life annuity benefit). If you are considering electing the lump sum, we recommend that you crunch your numbers using current annuity quotes and our ABC workbooks. You may also wish to consult a financial advisor. It is an important financial decision that is generally final when made.
