Almost every retiree I work with faces a huge question right at the beginning of retirement. The question is whether or not to take your pension as a lump sum or an annuity. As most of you know, the lump sum may double your investable assets-or at least substantially increase them. But, how do you determine what’s truly in your best intrests?

I want to start by putting a couple of things out in the open. First, I’ll explain my preference as to what makes sense most of the time (read: “most”…not all of the time!). And second, I’ll point out a huge conflict of interest in Wall Street that you should know about.

First, I really like taking the lump sum. Part of this is due to my enduring belief in the markets. The stock markets are not a nebulous void of risk and uncertainty. The markets are not a poker table that leaves much of your fate to luck. The markets are companies. Real companies. Real companies that you can purchase a stake of ownership in. Having this as the backbone of my beliefs, I am very excited about the coming decades and their potential for growth. Regardless of the current catastrophe taking place (whether it’s a real estate crisis, a geopolitical event, or a pandemic), I believe the strongest, most well-financed companies in the world will continue to serve their market and thrive. Will they experience a temporary decline? Certainly. That is a price you must pay to experience long-term growth in an efficient market. Taking the lump sum allows you to benefit from this. Plus, it ensures your family enjoys it regardless of what happens to you or your beneficiary listed in the annuity. But as I’ll point out later, this is not best for everyone.

Second, Wall Street has an enormous conflict of interest when they advise you on your pension decision. In fact, the popularity of the lump sum over the past two decades is directly tied to this factor. Wall Street firms make more revenue, and substantially more profit, by convincing retires to take the lump sum. If I’m running a wealth management firm that charges 1% of your assets, and half of anyone’s assets are often in the pension, that is a big conflict of interest. Picture that: those advisors get $0 if you take the annuity, and they get a lot of money ($10-$30,000+ every year–on top of your other assets) if you take the lump sum and let them manage it. Not that I’m saying all financial advisors are making selfish decisions, as there are certainly plenty of great ones. But imagine if you were faced with a business decision and convincing someone to choose a specific option doubled your revenue? And there’s a decent chance that choosing that option would probably work out. That’s a big conflict of interest–that’s why virtually every advisor is staunchly in the lump sum camp. As I’ve written before, that’s why I love my flat net worth fee structure. I want to minimize conflicts of interest where I can.

So, how do you determine what you should do?

When evaluating pensions, I divide it into two buckets. The first bucket is an almost-obvious take the lump sum scenario. The second is more nuanced and equal–the lump sum and annuity could both be in the client’s best interests.

By and large, the “obvious” lump-sum scenario is when there are significantly more assets than needed to fund retirement expenses. If someone has $7Mil total and only spends $7,000 per month, there’s no reason to take the annuity and limit future growth and the legacy they’ll pass down. Regardless of their relationship with risk, they’ll be able to meet their needs without any issue.

The other scenario is where both options could be in the client’s best interests. This is where assets are sufficient to cover retirement, but there are not dramatically more assets than needed (unlike the scenario above). So, how do we determine what’s better in these cases?

Interest rate impact on the lump sum-This is a big factor. Another way to say this: what’s the better deal between the lump sum and annuity?

-The risk tolerance of the individual. I’ll preface this by saying risk tolerance is often over discussed in financial planning. It is important, but it should never be the driving factor-your goals and your financial plan should have more influence over your portfolio. Handing someone a risk survey that asks them how they’ll feel when 1/3 of their money vanishes–answer: crappy–and then building their portfolio based on that is silly. Still, it is important as I’ll note below.

If someone’s risk tolerance is middle of the road or high, this is a big factor that can make the lump sum the better option. After all, history has a long record of showing that diversified portfolio will not only provide for retirement income but also provide a legacy to pass down. The annuity can do the first, but it’s not built for the second.

Now, on the other hand, if someone has a very low tolerance for risk, this should be considered in the decision. I mentioned just above that the lump sum has been the better option if you’re looking for retirement income AND a legacy to pass down. But, to provide income now and in the distant future, maintaining substantial stock exposure is an absolute must. If interest rates in bonds are giving us 2%/year, we will likely need 50-70% of the portfolio to be in stock funds. Otherwise, the returns won’t even keep up with the income needs of the individual each year, much less inflation. So, someone facing a 20-30+ year retirement likely needs a portfolio with substantial stock exposure. This means that on average, 1/5 or 1/6 years will include a 20-25% drop-some crashes could be worse.

In an efficient market, every attempt to use technical analysis to time the market will likely lower returns in a proportionate manner. So, I do really like the lump sum option. But to take the lump sum, the individual must be entirely content knowing that they will likely see a temporary decline in their principal to the tune of hundreds of thousands of dollars. And they must be ok knowing that could happen 5-6 times throughout their retirement. If someone has a minimal appetite for risk, the thought of $2,000,000 turning into $1,500,000 in just a few months might not be bearable. I didn’t even mention the smaller downturns they will face almost every calendar year (8-10% in a diversified portfolio). So, I said a few paragraphs earlier that risk tolerance should not be the cart that drives the horse. Still, if you cannot sleep at night while the market is crashing and won’t be able to stick to your portfolio, the annuity is likely better.

Sometimes I tell clients that my job is not to make them die with the most amount of money possible. If that is your goal, I know how to help increase your odds of that happening, but that’s not very fun. You need to enjoy your life now. If having a guaranteed fixed source of income to cover almost all of your expenses is what it takes, then it’s ok to do that.

-The specific makeup of your pension annuity calculation. Similar to a 401k, there are general guidelines that govern pension plans, but your HR or Benefits department still plays an enormous role in your pension. There are thousands of different pensions. They’re not all the same. I’ll be brief because this is similar to my first point above (interest rate impact). Big picture, sometimes your specific pension may give an unusually great deal one way or the other, and that’s obviously a factor to consider.

If you do take the annuity, understand your options

Joint survivor 50,75,100%: This means you choose a beneficiary and the annuity will last as long as one of you is alive. If you choose 100%, it will stay at the same level. If you choose 50%, it will be cut in half should you pass away first. As a blanket rule that doesn’t necessarily apply all the time, it makes a lot of sense to choose 100% if you’re a married couple with combined finances. Why work for a benefit for 3-4 decades just to have it cut in half if you were to pass away? If something happens to both of you early on, the annuity stops and does not pay out. This is another big plus for taking the lump-sum.

Period Certain 5,10,20 years: This means your annuity is locked in for the period you choose. You’ll notice the benefit decreases as you lengthen the period certain term. If you choose a ten year period certain, your annuity will pay out to whoever you choose for the rest of the period if you pass away. If you live for three years, your beneficiary has however many years remain on the term. It’s a guarantee that someone of your choosing will get the annuity for the duration of the term.

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