As indicated in our post of February 18, 2015, we generally recommend that individuals elect to receive a lifetime income form of payment from a pension plan when offered a choice between a lump-sum and a life annuity. Yes, we have heard from readers who believe we are wrong, and they tell us that they have done quite well, thank you, investing their lump sum distribution in the current bull market. We received similar comments from individuals who disagreed with our recommendation relative to borrowing and investing proceeds in a low-interest rate environment in our post of February 18, 2015. What can we say? Sometimes people take risks and are rewarded for doing so.
But, this is our blog, and we base our advice to retirees on basic actuarial and financial economics principles rather than aggressive investment strategies. In this post, we will discuss the May 5, 2022 Kiplinger article by Brian Skrobonja entitled, “Why a Pension Lump Sum Option Is Better Than an Annuity Payment.” For the most part, we disagree with Mr. Skrobonja’s conclusion and his rationale, especially for a household that needs the pension income to fully fund its Floor Portfolio.
After citing several dubious statements about the supposed problems with pensions, Mr. Skrobonja presents his argument that the real reason to chose the lump sum is because the lump sum gives you more control of your assets, and the lump sum can be used for many things theoretically not easily accomplished with a life annuity. We are going to push back on this claim to the extent it pertains to a household that needs the pension assets to fund their essential expenses.
As noted by Dr. Wade Pfau, in item 8 of his excellent article, “Eight Core Ideas to Guide Retirement Planning,” households should distinguish between technical liquidity and true liquidity. He says,
“A client is free to reallocate their assets in any way they wish, but the assets are not truly liquid because they must be preserved to meet the spending goal. This is different from free-spending liquidity, in which assets could be spent in any desired way because they are not earmarked to meet existing liabilities. While a retiree could decide to use these assets for another purpose, doing so would jeopardize the ability to meet future spending. In this sense, these assets are not as liquid as they appear.”
If a household needs non-risky assets like a life annuity to fund its essential expenses, it can’t also use those assets for other purposes and, based on financial economics principles, it should be investing those assets in non-risky investments as discussed in item 7 of Dr. Pfau’s article.
“At the core of these different methodologies is a desire to treat the household retirement problem in the same way that pension funds treat their obligations. Assets should be matched to liabilities with comparable levels of risk. This matching can either be done on a balance sheet level, using the present values of asset and liability streams [like we do in the AFP], or it can be accomplished on a period-by-period basis to match assets to ongoing spending needs.”
Households that do not need some or any of the pension plan assets to fund their essential expenses, can be more aggressive in selecting and investing a lump sum payment. For example, a household that only needs a portion of the lump sum to fund essential expenses could roll over the entire lump sum distribution and invest the portion needed to fund essential expenses in life annuities, or other non-risky investments, while investing the remainder in risky investments.
Some experts say that lump sums can be used to bridge the period during Social Security deferral. We have no problem with this strategy provided the household Floor Portfolio ends up being reasonably funded as a result.
Single retirees who have health issues that they are reasonably sure will compromise their lifetime planning period may also benefit by taking a lump sum, but the decision is not as clear for a health-challenged plan participant with a healthy spouse.
Conclusion
In our post of February 18, 2015, we encouraged plan participants who are offered a choice between a lump sum and an annuity to crunch their numbers before making a decision. In addition to pricing the current cost of annuities, we believe crunching numbers with the AFP can be useful in helping retirees make this important decision.
