Every so often we read something in the retirement-advice media with which we simply cannot agree. Recently, we ran across a video from Kiplinger entitled, “Why A Pension Lump Sum is Better than An Annuity Payment.” This video appears to be based on the May 5, 2022 article by Brian Skrobonja, CHFC, (updated on January 27, 2023) entitled, “Pension Lum Sum vs. Annuity Option, Which Is Better?” When the article was first released last year, we took issue with it and discussed its shortcomings in our post of May 5, 2022. If you are interested in this subject, we encourage you to re-read our post of May 5, 2022.
With its new video, Kiplinger ratchets up its level of fear-mongering by implying that if you elect the annuity option, there is significant risk that you may not receive the full value of your promised pension. Because of this supposed risk, Kiplinger concludes that you will always be better off taking the lump sum rather than the annuity. To support this conclusion, Kiplinger claims, “Even if the income generated from the lump sum is less than the promised annuity payment, you gain control over the assets.” Yes, it is true that taking the lump sum will give you more control over your assets, but electing the lump sum isn’t always the financially prudent thing to do, and certainly not if the income that may be generated from the lump sum is significantly less than the promised annuity payment.
Defined benefit pensions vs. defined contribution benefits.
Interestingly, we read a different article on May 1 entitled “The Retirement Crisis: 15 Reasons Why Baby Boomers are Facing Financial Challenges.” One of the 15 reasons was “Lack of Pensions” about which the authors said,
“Due to the transition from traditional pensions to 401(k)s and other defined contribution plans, many baby boomers don’t have a guaranteed pension plan. This shift puts the responsibility of retirement savings squarely on their shoulders, leaving them more vulnerable to market fluctuations and investment risks.”
So, apparently more control over pension assets also comes with more responsibility to manage those assets and more vulnerability to market fluctuations and investment risks. According to these authors, at least, this is a negative and not a positive for many retirees.
What is the risk of receiving less than the full value of your pension?
How much payment default risk is involved with electing the annuity option? For most plans there is very little risk, especially if the plan sponsor is financially healthy. Upon a standard plan termination, plan sponsors must either satisfy all plan liabilities through purchase of life annuities or by distributing the lump sum value of plan benefits to those who elect a lump sum. Those plan sponsors who cannot satisfy all plan liabilities upon a “distress” plan termination must transfer plan assets and plan liabilities to the Pension Benefit Guaranty Corporation. For those few plan sponsors who are unable to satisfy all plan liabilities, the PBGC estimates that only about 15% of affected plan participants will experience benefit reductions because their benefits are not fully guaranteed by the PBGC (mostly active plan participants). In many cases, the law will also restrict payments of lump sums by plan sponsors who may not be able to pay full annuity benefits.
Importance of Crunching the Numbers
Converting annuities into lump sums and lump sums into annuities involves (generally government specified) assumptions about interest rates and mortality. The interest rates used in the conversion calculations have increased significantly over the past two years, so over this period, minimum lump sum values have decreased for a given annuity value and annuity values have increased for a given amount of lump sum value. As discussed in previous lump sum vs annuity posts, it is important to compare available lump sum values with the cost of annuities that may be purchased in the open insurance market (for example from ImmediateAnnuities.com) and it is also important to see how the lump sum vs. annuity decision will affect your household balance sheet using the Actuarial Financial Planner (AFP). Typically electing the annuity will strengthen the household balance sheet more than electing the lump sum.
Summary
Having control of your pension assets is not the end all or be all of financial planning in retirement. If you need to use the pension assets to fund your essential expenses, electing the lump sum option and investing the proceeds in non-risky investments (to match your risk tolerance for reducing your future essential expense liabilities) will generally be less efficient than electing the annuity option, and as discussed in our post of May 5, 2022, there will be no greater “true liquidity” or spending flexibility in doing so.
Contrary to the Kiplinger claims, there is very little payment default risk associated with pension promises or life annuities, and these types of relatively non-risky investments are excellent “floor” portfolio assets designed to efficiently support your essential expense spending liabilities.
