Early Retirement - Financial Freedom (Investing, Tax Planning, Retirement Strategy, Personal Finance)

Pension Decision - Lump Sum or Annuity?

• Ari Taublieb, CFP®, MBA • Episode 199

Share episode

Choosing between a lump sum distribution and an annuity for your pension can be one of the most pivotal financial decisions you'll ever make. What could potentially put more money in your pocket—a flexible lump sum with inheritance potential or the security of guaranteed lifetime income with an annuity? Join us as we unpack this complex choice, exploring the benefits of each option through detailed analyses and real-world examples. Learn vital insights, such as tax implications and the optimal way to transfer a lump sum to an IRA, with guidance from our most recent client case study. 

In this episode, we'll demonstrate how a $179,000 lump sum compares to a fixed annuity over different timelines and growth scenarios. Discover how early death could affect inheritance, the advantages of maintaining flexibility for Roth conversions, and which choice aligns best with your financial goals and comfort level with investments. Whether you're leaning towards guaranteed income or eyeing potential growth, our thorough comparison aims to equip you with the knowledge needed to make an informed pension decision. Don't miss our detailed visual breakdown on YouTube for a more immersive learning experience!

Create Your Custom Early Retirement Strategy Here

Get access to the same software I use for my clients and join the Early Retirement Academy here

Ari Taublieb, CFP ®, MBA is the Vice President of Root Financial Partners and a Fiduciary Financial Planner specializing in helping clients retire early with confidence.

Speaker 1:

You have a pension decision to make and I'm going to help you make it in 10 minutes. You're wondering right now what is going to put more money into my pocket. Is it taking the lump sum distribution or is it taking the annuity distribution? Both have their benefits, and especially a lump sum, because when you take that, you can go well. This is pretty cool. I can take it and invest in whatever I want and, if God forbid, something happened to me tomorrow, my heirs inherit all of this money. Now, with the annuity, it also feels nice because you go well, I get this guaranteed income for the rest of my life and there's different options there. Does your spouse get a hundred percent If something happens to you? Do they get 50%? Is it worth the trade off of that? I'm going to help walk you through how to think through a pension decision and I'm going to actually show you one. I did with a client.

Speaker 1:

So welcome back to the Early Retirement Podcast. I am your host, ari Taublieb. I am a certified financial planner. I am the host of the Early Retirement Podcast that you're listening to right now, and I'm the vice president here at Root Financial Partners. So, with that being said, a few quick announcements financial partners. So, with that being said, a few quick announcements. The first is that I am going to be showing you today, right now, an internal rate of return analysis. Some of you have never heard of this before. And the same way, I went to my doctor and they told me to take a pill I had never heard of before. So it's not something that I'll go over often with clients. But I actually want to go on more of the technical side today, just so that you know, if you are trying to make that decision for your pension, you make the right one, because it has a lot of different factors and it can really dictate what a successful retirement might look like for you. If you do not have a pension, you might still find this episode interesting. But you can apply a similar analysis to if you have an annuity right now and you're wondering, hey, should I get out of that annuity? It's guaranteed with all this stuff, but I don't know if the fees are worth it and what about the surrender charges? So this is really an analysis to determine okay, should I take lump sum or annuity? But it can go deeper if you have another product that you're wondering how to think through that. So I'm going to hop right in after I go over the review of the week, and this review comes from cool 0867, who says anyone who's considering an early retirement it's a must listen. Ari creates great content for his audience and truly cares about helping people achieve their dream of an early retirement. So thank you for that comment. That is a comment from the podcast app.

Speaker 1:

Now, for a lot of you, what I imagine you're wrestling with and I could be wrong, but you're going look, right now I have got a decision to make. If I take the lump sum, first of all, I just don't even know where would I put that money? How would I invest that money? It would be a lot all at once. So it kind of feels odd and I like the idea of guaranteed income. So I want to take it, but I just want to make sure I'm doing the right thing and I'm not like missing one giant thing. So a few things. Number one there is a flow chart that is in my academy that's going to help you think through Should you take the lump sum, should you take the annuity, in conjunction with what I'm going to show you right now. So I'm going to distill all of this for you, but some of you I'd say a large portion of you are actually listening on the podcast app, which is awesome. That's why I do this, so I'm going to continue to do that. But what I'm going to be showing today is also going to be on YouTube. So if you're going, hey, I want to be able to follow along with what numbers you're showing, because there are going to be a lot of numbers. You can go to YouTube and you can see exactly what I'm going to be showing. I'm going to explain it so you don't need to be on YouTube, but just want to give you guys that option, so I'm going to hop right in.

Speaker 1:

This is a pension analysis that I just did for a client. So what you're going to see on my screen right now is this person who has the option. They have the option Now. This person's single, so they're not worrying about their heirs, but I'm going to pretend, what if they did in a second? This person's single and they don't have any children, and so they're wondering what do I do? Should I take this pension that's going to guarantee me $1,081 every month for the rest of my life? There's no cost of living adjustment. So it's just $1,081 every month for the next 50 years if they live 50 years, or $179,000 immediately.

Speaker 1:

And by the way, big confusion here for a lot of people If you take that lump sum amount, that does not. You do not want to take that money and put it into your bank account because you'd have to pay taxes, a lot of taxes. All of that would be taxed. So what you do is you move that money to an IRA, an IRA pre-tax account. So you would have that option. So just to be clear, don't move it to a brokerage account or take it as cash. I've only seen that once where someone did it on accident and they paid 40% taxes on that $179,000. Except theirs wasn't $179,000. It was $800,000. You don't want to do that. So only saw it once and we were able to amend it due to paperwork stuff. So if you know who you are and you're listening to this, they're laughing back going oh my gosh, I can't believe that would have been a big mistake. So I know a lot of my clients are still listening to the episodes here.

Speaker 1:

So here's what's called an internal rate of return analysis. So option one on the column C here, and I'm going to explain it if you're just listening to the podcast is $179,000. That's their option of just taking it all at once, or $12,972 every single year, forever. So what you're going to see on the right is what's called the internal rate of return. This is saying what is the return you received each year. So let's assume after one year you pass away. So you just say I'm going to take the annuity, but then you pass away. Your internal rate of return is negative, 92.75%. Why, well, what happened is you received the $12,972 and that's it. You passed away.

Speaker 1:

Now, in their case, they don't have a spouse. So most of you guys, if you have a spouse or and it can't be children it can only be a spouse. Your spouse can be eligible for oftentimes a hundred percent, for it's going to be a smaller amount, or for 50% or 75%, where it would be a larger amount for you, until you pass away, and then it's 75% of that for the rest of their life. So more often than not, I will elect if we are doing the annuity option and it's based on how good a pension is, by the way, that's how you make this decision is I will do the 100% spouse option, so it's called 100% joint and survivor.

Speaker 1:

If someone has a spouse and they're debating, what do I do? But let me show you the analysis so you can hear. If they passed away after one year they would have received a negative 92%, because if they take the 179,000, that could have grown. And if after one year they passed away, it could have gone to heirs, it could have gone to charities, it could do whatever they want. That is their money tomorrow for the rest of their life.

Speaker 1:

So the way to think about this is if we continue going down the line here, at what point does it start to make sense? At what point is it a positive return by taking the annuity option? And you can see here year 15 is where the annuity option would be positive. You can see about 1%. So not a good return, but positive. Now, if we continue to go out here, the longer you live, the more attractive the annuity option is is because they're paying you out more and more and more. So what you can see here is, after 35 years their return would be about six and a half percent.

Speaker 1:

So the question is if this person was 50 years old and they knew, now they're not 50, they're 60. So if this person's 60, I'll use them as an example and they live till 95, they would have gotten a return of 6.43%. So I will ask them I'll go do you think that's a good return? And some people go, yeah, it's a great return. I can guarantee if I live for 35 years I will get a 6.43% return. Like that's pretty awesome and I'll say it is.

Speaker 1:

But yours is not accounting for inflation, so that 1,081 a month. That is not rising with inflation. So really, even though this says 6.43%, it's really not six and a half percent. Let's call it. It's really more like three and a half percent, because inflation is also going and growing and let's assume it's growing at three percent. Well, if six and a half percent is your return on paper and inflation is three percent, we have to subtract that. So 6.5% minus the 3%. So now you're working with 3.5% as your real return, your inflation-adjusted return.

Speaker 1:

So this is not an example where I would say let's take the annuity option, especially because that lump sum of $179,000, well, I just know, if we're looking at markets historically, you can do a whole lot better than 6.5% average over 35 years. So on the next page that I'm going to show you guys and once again explaining it, in case you're just listening, which is totally cool. What I want to now understand is what would be what's called the cumulative annuity that you would have brought in over time, meaning, how many dollars would you bring in if you were to add up receiving $12,972 every single year for 35 years, you would have, as a total, brought in $454,000 over 35 years. So that's pretty cool. Over 35 years, if you said I want to take the guaranteed annuity option, you get $12,000 every single year. You add that up, you've got $454,000.

Speaker 1:

Now what we want to understand is that lump sum. How much income could that create for us while we're alive? So I'm taking just a sustainable withdrawal rate amount and I'm applying that logic to the lump sum. So if your lump sum is $179,000, if we were to take just starting out, let's just say, five and a half percent, which can be on the high end for some and low end for others, but I just want to take this just as a conservative figure here for a second. This is not similar to the 4% rule. This is a different analysis, where, if you're taking from the pension, $179,000 is not similar to the 4% rule. This is a different analysis where, if you're taking from the pension, $179,000 is your lump sum balance. If you took five and a half percent of that in the first year, that would be $9,800. So with the annuity you could guarantee about $13,000 in a year and with the lump sum you can guarantee about $10,000. So it's $3,000 less with my lump sum recommendation.

Speaker 1:

Now why would anyone do this? Well, it starts out as 9,800 bucks, or let's call it 10,000. And then what happens is it continues to grow because that $179,000 is growing every single year. So what happens is at the beginning it's only throwing off $10,000 a year, but as it grows, by year 11, it's now beat the annuity and now it's bringing in $13,000 a year versus $12,000. So some of you are like well, I get that it's bringing in $13,000, but is it? You know, I would have had a guaranteed $12,000 every year.

Speaker 1:

The one difference here and this is an important piece of the analysis is if after 10 years, you passed away and you took the annuity option, you brought in $130,000 and that's it. So $130,000 came in and then it was done. So Versus, if you did the same analysis after 10 years with the lump sum, you would have brought in $112,000 total, meaning just income it generated. You can see here, guys, that was you're hearing that in live time. That was the outro of the episode starting to play immediately, so trying to interrupt my pension analysis. Okay, so sorry about that.

Speaker 1:

Back to this, so that $112,000, that's the income your $179,000 would have generated in total. Meaning you take $9,000 the first year, then $10,000, then $10,500, then $11,000 and so on for a total of $112,000. But if after 10 years you pass away, so on for a total of 112. But if after 10 years you pass away, it wasn't just 112 and that's it. That 112,000 goes on to your heirs and it could go wherever you want.

Speaker 1:

So what we want to always understand is what's going to put the most money in our pockets at the end of the day. And at the end of the day, the lump sum would have brought in a total after 35 years of $600,000. And if you pass away in year 30, where there's 460,000 of value, that 460,000 goes to whoever you want. So there's a lot of value in that. Once again, in total, $460,000, that's what you created in income over the last 30 years.

Speaker 1:

But then, whatever is the value of the account left, you also get to give to your heirs, versus with the annuity option. It doesn't work that way. Whatever you're inheriting, whatever income's coming in, that is great. But then when you pass away, it goes away, unless you have a spouse. So if you have a spouse, the difference to the analysis is you want to shift the numbers, so I'm going to do it on my screen here, in case you're on YouTube.

Speaker 1:

So, instead of this saying 12,972, what if we switch this to 11,000? Because more than likely, if you're going to take that joint and survivor option, the company that's giving you that choice they're going to say, hey, if we're going to have to pay your spouse after this, we're not going to give you as much money, because that just wouldn't benefit us. So now, if you look at the return, instead of six and a half percent being the return after 35 years, it's only five percent, it's only 5%. So what you always want to do is run the numbers on your pension, because I see some pensions that all in, are guaranteeing about 10 to 12% and if I see those numbers, that's going to beat any strategy that you can conservatively look at if you're trying to invest the right way. But if you're looking at anywhere in the range of three to 6%, that's where I tend to say, hey, that lump sum might make more sense. Now some of you guys a few considerations to think of are going look, I get that, but I'm just going to sleep better knowing I've guaranteed income and, yes, I know it doesn't have an inflation adjustment, but I'm just going to sleep better. Well then, great, you can do that. Others of you are going to go. No, I'm comfortable investing, and because of that of you are going to go. No, I'm comfortable investing, and because of that, I think this lump sum option makes more sense.

Speaker 1:

The other option and the reason I like going through this type of example with a pension once your pension gets turned on and social security is turned on and required distributions are turned on, you might have a lot of income coming in. So if you're thinking about doing Roth conversions, you more than likely want to select the lump sum option, because once this pension gets turned on, it cannot get turned off and what happens is that's sending you more income, which is good so you can live, but it's also filling up your tax brackets. So now, if you want to do Roth conversions, you might be having to pay taxes at the next tax bracket, which makes it less optimal for you. So whether you should collect your pension lump sum or annuity is dependent on your current pre-tax balance, your comfortable, really, your flexibility with investing and comfort surrounding the subject, as well as what that means for the rest of your family. So lump sum versus pension this is just a sample as to how I would look through it.

Speaker 1:

Hopefully a quick episode and gives you the insight you want on thinking through pensions. So that's it for today's episode. If this was helpful, please do like, please do share. If you want a copy of this type of analysis, it is in my academy. So in the early retirement academy you will see there's an option to create your own analysis. I've already put the code in here that I use so you do not have to worry about going hey, if I'm not like an Excel whiz, how am I going to be able to do this myself? So don't worry about that, it's just already in there. So this is how to think through it. Hopefully this is helpful for you guys and I will see you guys next time.

Speaker 1:

Thank you for listening to another episode of the Early Retirement Show. If you have a question that you want answered in a future episode, you can always go to my website, earlyretirementpodcastcom. That's earlyretirementpodcastcom, and you can go ahead and submit a question that I'll look to answer in a future episode. Thank you all for listening. Please do rate it, review it and share it with someone who you think would benefit from this information. If there's anyone out there that you know, I certainly appreciate it and I will see you all each week. Hey guys, it's me again. Please be smart about this. Nothing in this podcast should be construed as financial, tax or legal advice. Consult with your tax preparer or financial advisor before taking any action. This podcast is for informational purposes only.