As one approaches retirement, if you're lucky enough to be the beneficiary of a pension plan, there is often a big decision to make regarding choosing an annuity or taking a rollover of a lump sum from a defined benefit plan. Of the companies left that still provide a defined benefit plan offering a pension, some offer the choice, many do not. For this analysis I will examine my own benefit as I can calculate my pension or lump sum payment anytime I wish. I have found that the road to the eventual decision is complicated, with many cross currents to muddy the choice. I will examine each side of the choice and hopefully the process can help those facing this decision themselves.
First off, I went to my benefit section and sourced the numbers that would be my personal choice based on a retirement at age 65. I then changed the numbers so that it reflected a comparison based on a $100,000 lump sum payment and adjusted the pension annuity by a similar calculation so that anyone could translate it to their own personal plan.
This assumes, of course, that most defined plans are calculated in a similar fashion. Pension annuities are calculated based on salary and years of service. Lump sum payments are based on an interest rate supplied by the government to "equal" the annuity. As rates slip lower, the lump sum payment increases. The pension annuity does not change with interest rates. Furthermore, inflation considerations are disregarded as most pension annuities do not include that feature. If an individual has an inflation protected annuity, then that is a very valuable feature to consider.
In my case a lump sum payment of $100,000 equals a lifetime annual annuity of $7,824. I did not use a spousal annuity in this case, just to keep it simple. In order for me to obtain a monthly return of that amount, and not spend any of the lump sum, I must have a constant return of 7.82% or higher. While that return is not out of bounds with historical stock market returns, it does not insure a guarantee of lifetime payments. The problem lies with the volatility of the market itself. For this study I have used historical total returns of the stock market as measured by the S&P 500.
I chose several time frames to show results. There are many starting points in which the funds grow to large numbers as well as many periods where the funds ran out.
The following table shows the results for someone retiring in 1995 with the funds 100% invested in the stock market, withdrawing $7,824 per year. Beginning in 1995, our retiree would survive with the 7.8% payout. This investor was bailed out by the market's five good years from 1995 to 1999. He finds himself at the end of 2010 needing only about 50% of the original withdrawal percentage to finish retirement. In this example, I used the gain of $38,020 for 1995 added to the starting balance of $100,000. All other numbers in the "Investment Gain/Loss" are the value in the last column times the market return.
However, if one retired in 2000, the story is much different. By the end of 2010, this individual is down to his/her last pennies as the market's lost decade offered little return.
Beginning retirement in 1966 resulted in depleted assets in a little less than 20 years. If I had offered an off-the-cuff guess about the results starting at this time I would not have guessed that the funds would not have lasted nearly 20 years, but closer to 12-14. That goes to show that opinion is a poor metric on which to base one's finances. Click to enlarge:
However, had you the good fortune of retiring in 1974 with the current lump sum, life would have been great.
The crux of the situation is simple. If one needs the guarantee of the current income that a pension annuity payout provides, then take it, as the stock market returns could destroy your retirement. However, if one can settle for a lower payout until they get through a bear market period to stabilize the market value, then a full payout might work.
One article that I read recently made the case for a payout above 7% based on the time that one retires. If market valuations are in the lower tier of historical levels due to recent bear markets, then higher payout levels can be justified. Clearly, the examples above support that theory. The retiree, of course, must make the decision if the market is a value at the time of their retirement.
Suggestions for ways to extend the life of your funds:
1. Reserve 2-3 years retirement needs in cash so that withdrawals are not required if market returns are poor.
2. Supplement the reserve with income distributions from dividends to delay the need for capital or principal distributions. For example, if one has a portfolio with a current yield of 4% supplementing a 3 year reserve, the reserve should then last almost 5 years before any other distributions are required.
3. Withdraw less the first few years until the funds increase in value.
4. If one does not need a full 7.8% payout, then take less.
5. Work another year or two to build a larger payout, but with the idea of only spending today's income at that time.
6. Buy high yielding dividend stocks, and putting the withdrawal needs on the back of dividends rather than capital gains. This, of course, changes expected returns from the stock market and triggers changes in future growth as well as risk factors.
7. Replace some equities with higher paying bonds or other high interest rate instruments, if available.
8. Add income to the portfolio by writing options. This will also change the returns as stocks may be called reducing one's stock market returns.
9. Market timing. Good luck with that one as it might cause more harm than good.
10. Work part-time, reducing the need for a full withdrawal.
Hopefully, for those retirees that have the luxury of having a defined benefit plan, the examples shown will help one to make an better informed decision. I plan on taking the payout but reducing the level of withdrawals for the first few years or forever, setting aside 2-3 years of income needs, building a dividend growth portfolio, selective option writing, and using dividend income to supplement the reserve.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.