Lump Sum vs. Pension: Which is Better for Guaranteed Income?

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A friend nearing retirement asked me whether she should take her employer’s retirement plan in the form of a pension or a lump sum. The lump sum is attractive. She could use this money to seed investments in the stock market and pay off her mortgage. The pension is also appealing. It provides a predictable monthly income, which seems more secure than stock investments and provides a steady way to pay monthly bills including the mortgage.

To get started with analyzing this decision, I consulted The 7 Most Important Equations for Your Retirement by Moshe A. Milevsky. This book explains the rationale and calculations associated with pension plans. It includes tools to determine which is a better deal, lump sum or pension (monthly payment). What I discovered is two-fold: 1) we can apply financial formulas and financial-services shopping to developing a math-based opinion based on expected longevity, prevailing interest rates, and market prices; and 2) there are non-math-related factors when making this choice.

Further, I realized there are many angles from which we could approach this pension-or-lump-sum dilemma. For this analysis, I’ll consider that my friend wants to generate as much guaranteed income in retirement as possible. We’ll look at three different scenarios:

  • income produced by accepting the pension
  • annuity-based income available on the open market (that is, an annuity purchased with the lump sum amount)
  • income generated from interest earned on the lump sum

I’ll also calculate the internal rate of return for average life expectancy and compare this number with the current interest rate for the company’s offer.

Look at income from the employer’s pension

The first steps are to review the monthly income you’ll receive from the employer and note the amount of money being offered as a one-time, lump-sum payout that relieves the employer of further obligation.

Let’s say you’re 65 years old, being offered $200,000 as a lump-sum payout vs. a $1,000 monthly check for the rest of your life. This monthly income will serve as our benchmark in comparing this arrangement to alternatives.

For these calculations, I’ll figure that you’ll live until 86.5, which is the life expectancy for a 65-year-old woman according to  the Social Security Administration website (or use 84 as your life expectancy if you’re a 65-year-old man). We’ll also use 2.2% as the prevailing interest rate; this rate is the highest I could uncover on a certificate of deposit with a 10-year term (note that interest rates are subject to change).

In terms of internal rate of return (IRR), if you live an average number of years, the interest rate being offered through the pension is 2.65%, which is greater than the prevailing interest rate. So, the pension (income) is a slightly better deal than the lump-sum payout.

Compare the employer’s offer to annuities on the open market

Now, we’ll move to comparing the employer’s offer with those available on the open market.

According to Milesvky, employers tend to offer better deals than outside annuity providers. But the only way to know for sure is to compare an employer’s offer with offers on the open market. Gather the specifics and do your research.

In the scenario mentioned earlier, how much monthly income via a fixed-income annuity could a $200,000 investment buy?

A few places to get estimates and quotes without having to contact a sales representative are Blueprint Income, Schwab, and Fidelity. You can read more about obtaining annuity information in my article, How to Obtain Annuity Quotes.

Here are estimates of the monthly income with a lump-sum payment of $200,000 (starting at age 65 and continuing until death):

  • $970 per month for life
  • $965 per month for life
  • $975 per month for life

If you have been offered a $1,000 monthly payment for life from your employer and you’re looking for guaranteed payments, then the monthly pension from work is a better deal math-wise than buying an annuity on the open market. That’s because, your $200,000 buys you $965 to $975 on the open market whereas you’ll receive $1,000 monthly from your employer.

As you review the choices, determine how confident you are that your employer has the ability to sustain payments over time compared to that of your chosen annuity provider/insurance company (the type you’d trust with your lump sum in exchange for an annuity).

Calculate how much guaranteed income you could generate on your own

Rather than rely on your employer or an annuity provider, you could create a stream of income on your own. Using this approach, you could pay yourself a specific monthly amount, drawing upon the lump sum and the interest earned by this money.

Gather this information:

  • your current age
  • interest rate on highest yielding federally-insured account
  • average life expectancy
  • lump sum amount

Drawing on our scenario, let’s say these numbers are: 65, 2.2%, 86.5, and $200,000. If you received the lump sum and put this money in a savings account, earning 2.2% annually, you could pay yourself $973.62 monthly from age 65 to 86.5.

Here’s the formula to calculate your payment to yourself: =PMT (interest rate, number of periods, present value, future value). More specifically, =PMT(2.2%/12, (86.5-65 years)*12, -$200000,0) = $973.62 per month.

So, if you lived a statistically average number of years and you could get today’s interest rate indefinitely, you could create a stream of monthly income. This level of income would not be as valuable as the employer’s pension for a couple of reasons. First, your DIY income is less than your employer’s pension. Second, your income would end when you turn 86.5 whereas the employer’s pension would last as long as you live.

However, if interest rates increased and you could earn say 3% in a savings account, then you could generate monthly income of $1,052.82 from 65 to 86.5. If you could start earning 5%, you’d be able to collect over $1,000 until you turn 100. On the other hand, if bank interest rates fell to 1%, you would bring home just $861.83.

Consider benefits and risks among choices

I’ve put together a spreadsheet showing my calculations relating to the benefits of various choices.

Here are the main risks:

  • default risk: the risk the employer or insurance company will default and fail to pay you the full income promised
  • interest rate risk: the risk that interest rates will change, either 1) rising, causing you to miss out on opportunities to increase your income if you lock yourself into a pension or annuity contract or 2) falling, preventing you from collecting the originally-calculated income for yourself
  • longevity risk: the risk that you’ll live a long time and need monthly income past your average life expectancy, relevant to the do-it-yourself income stream

You might also be concerned with inflation risk, the risk that inflation will reduce the spending power of your income. You may be able to buy inflation riders but these may offer small protection for a high cost. Taking the lump sum and investing the money protects you from inflation risk, but won’t generate guaranteed income.

If you’re looking to get a guaranteed stream of income, compare your lump sum vs. pension choices to determine what’s the best deal and what’s preferable for you.

How did you decide between a pension with monthly income and a lump-sum payout?

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