August 22, 2023 • 26 mins
How can rising interest rates impact your pension value?
In this week's episode, we analyze a real-life scenario from our listener, Mark, who is weighing the pros and cons of an early retirement, a higher lump sum, or a commit to an annuity.
Learn how to calculate the imputed returns of an income annuity and how to determine if taking the lump sum and investing it would be the better option.
Questions Answered:
What considerations and calculations can be used to decide between a lump sum payout or an annuity?
Are you working against yourself by continuing to work?
Timestamps:
0:00 Intro
2:40 Mark's question
4:24 Unpacking it
7:38 Don't do your analysis this way
14:09 Here's how to do your analysis
18:54 Risk
19:58 Planning
20:50 Takeaway
24:47 Outro
Create Your Custom Strategy ⬇️
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:00):
Making the right decision about whether to
collect your pension as a lumpsum or as an annuity can be one
of the most important and themost difficult decisions to make
when it comes to yourretirement.
On top of this, the fact thatinterest rates are rising so
rapidly makes this an even morechallenging decision.
So in today's episode, we'regoing to go over an actual
example of how should you thinkabout this decision in the
context of your specific plan,so you can do what's best for
(00:22):
you.
This is another episode ofReady for Retirement.
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
Many of the episodes I do areevergreen to an extent, meaning
whether you listen to it in 2023or 2020 or 2030, a lot of the
(00:45):
principles will be the same.
And while many of theprinciples of today's episode
will be the same, it's verytimely to an extent, at least
for those of you who have sometype of a pension, and the type
of pension we'll be talkingabout today is really corporate
pensions, so private pensions,not a government pension that
just has different details abouthow it's run and the benefits
that you can get from it.
(01:05):
But the reason this is timelyis because interest rates are
rising.
Not only are they rising, butthey're rising rapidly.
Now, if you understand howpensions work, typically within
a corporate pension environment,you are given an option where,
if I were to work for a companyfor some number of years, they
might say James, we will pay you, let's say, $1,000 per month
for the rest of your life withthe annuity option for this
(01:27):
pension or if you don't want totake a monthly annuity, that's
guaranteed for the rest of yourlife, james will also give you
the option of taking a lump sumrollover of maybe $250,000.
I'm just making up some numbershere, and so that's an option
that's presented.
Here's the thing, though thelump sum option that $250,000 in
this example I made up thatnumber fluctuates based upon
(01:50):
where current interest rates are, and as interest rates rise,
typically the annuity company orthe pension company is going to
decrease the amount I'meligible for as a lump sum.
So even if the annuity staysthe same, so the monthly amount
of $1,000 per month, the lumpsum amount that I could get
instead typically decreases asinterest rates rise.
(02:12):
So that's why it's timely.
Interest rates haven't justrisen in the last 12 months 24
months but they've risen rapidlyand so this is causing a lot of
turmoil for people who havepensions as they're trying to
determine what's the best optionfor them.
So this episode is based upon alistener's question, and this
listener's name is Mark Marksays this he says love the
podcast.
(02:32):
I really appreciate the realworld use cases and the way you
cover things to consider, asthere's no one right answer that
covers all scenarios.
I am lucky enough to be part ofa pension program at a major
auto company.
My question is whatconsiderations and calculations
can you recommend to decidebetween taking a lump sum payout
or an annuity?
I've always leaned towards alump sum.
(02:53):
However, with rising interestrates, the 2023 lump sum amount
dropped by 20% and I expect the2024 amount to drop
significantly as well.
My goal is to retire in 2024 or2025.
The company sets new pensionrates each year based upon rates
in August.
Therefore, I may have to make adecision again this year to
retire early to grab a higherlump sum.
(03:14):
If I don't, I feel like I'mcommitting myself to taking the
annuity.
I would be 57 that year.
Some data on my pension If Iretired before November 30th of
2023, then I have two options,and those options are as follows
.
Option number one I could take alump sum of $1,021,200.
(03:34):
Or option number two, I couldcollect an annuity with a
lifetime payment of $4,351 permonth, with no cost of living
adjustment.
In addition to this, therewould be an interim supplement
of $950 per month between thetime I retire until I turn 62.
Marketing goes on to say if Iretire next May, the annuity
(03:55):
moves to a lifetime amount of$4,923, with a monthly
supplement of $2,134 until Iturn 62.
There's a big jump when I hit30 years of service.
Of course, I don't know thelump sum value for next May
until the new rates arepublished.
Based upon this year's rate,however, next year's lump sum
amount would be $1,194,267, butI suspect it might drop by 15 to
(04:21):
20% due to the rate increasesthat occurred since last August.
I will learn these new rates atthe end of September and I'm
looking for guidance on how tomake this decision on what
option to consider.
So that's Mark's question.
Mark, it is a good question andthere's a lot of details to it,
so let me unpack that realquick for all other listeners as
we look at these numbers.
(04:42):
Mark's in a good spot.
He has a healthy pension.
He can select either a called amillion dollars lump sum
payment or he could collect$4,351 per month as an annuity,
and that annuity would pay Markevery single month for as long
as he lives.
Here's the predicament Mark'sleaning towards the lump sum
payment, so leaning towards thatmillion dollars.
(05:02):
However, if he stays an extrayear, the annuity amount would
increase.
So if he were to collect theannuity amount instead, instead
of the lump sum, that's going togo up because that's based upon
years of service.
However, the lump sum amount,which is also based upon years
of service, also incorporatescurrent interest rates.
So he's asked himself am Igoing to be essentially working
(05:25):
against myself by continuing towork, because that might mean I
actually collect less of a lumpsum payment a year from now or
two years from now than I'd beeligible for if I went to retire
sooner than that.
So that's his predicament andthat's what we're going to
address in today's episode.
But before we do so, I want toquickly highlight the review of
the week.
This review comes from usernameAnne Ford Travel.
(05:46):
Anne Ford Travel gives apodcast Five Stars and says I'm
learning so much from James'sYouTube and podcast on
retirement.
He's an excellent communicatorand a thoughtful teacher.
His contents are full of greatinformation and thought
provoking insights, and alistener's podcast will drive
him to work gardening or doinghouse chores.
I am much more confident aboutpreparing for my retirement
because of James.
(06:06):
Thank you for being a greatteacher.
Well, anne Ford Travel, thankyou very much for that.
That's why I do this.
It's amazing to see all thefeedback that we get, so I'm so
happy to hear that this podcasthas helped you to feel more
confident in your retirement.
And for those of you who haveleft reviews, thank you very
much for doing so.
If you've not already done so,please take a moment and leave a
Five Star review if thispodcast has been helpful to you.
(06:28):
And with that, let's get on tothe episode.
So multiple considerations.
As with anything, there's veryrarely a right or wrong answer,
and very rarely does it justcome down to one single
consideration.
In this case, there'sconsiderations like maximizing
income, there's maximizing peaceof mind, there's understanding
longevity risk, there'sunderstanding tax implications.
(06:50):
So there's a lot to it.
But the first thing I'd want tolook at is, quite simply, which
option is going to maximizeincome?
What option is going to put themost money in your pocket at
the end of the day.
This is what Mark is askinghimself.
He's asking himself should Itake this million dollars as a
lump sum?
And, by the way, when you takeit as a lump sum, if you roll it
(07:13):
over to a traditional IRA, youavoid tax implications.
So you know some people rightaway.
They say, well, don't take thelump sum, there's a huge tax hit
.
Yes, there is if you take it ascash.
But in this case I'm going tomake in the assumption that he
rolls it over to an IRA, whichwould be a tax-free transaction.
So does he take the milliondollars as a lump sum or does he
take the $4,350 per month andcollect that as an income
(07:36):
annuity for the rest of his life?
Well, here's how you shouldn'tdo the analysis.
I'm starting with how youshouldn't do the analysis
because this is where mostpeople go to first.
Most people do this.
They would say, okay, well,mark is eligible for $4,351 per
month.
That equals $52,212 per year.
(07:57):
So Mark could get $52,212 peryear.
And we want to compare that towhat could the lump sum create
in monthly or annual income ifit had been rolled to an IRA
instead.
So the analysis would thencontinue.
Okay, if the lump sums$1,021,200.
And, by the way, quick sidenote, just because those numbers
(08:19):
are kind of long, I'm going toround the lump sum to a million
dollars.
I'm going to round the annuityto $4,350 per month.
The actual numbers I'm going tosay to you, or the analysis, is
going to be based upon the realnumbers.
But just to keep things simple,as you're trying to follow
along with these numbers, I'mgoing to use nice round numbers.
I think doing so might makeyour head hurt less as you're
(08:39):
trying to follow along.
Hey, everyone, it's me again forthe Disclaimer.
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
So let's do this.
If you take the 52,200 per year,which is what the monthly
(09:01):
annuity turns out to over 12months, and divide it by the
lump sum that Mark could receiveof about a million bucks, what
you come up with is 5.1%.
So what some people would sayis okay.
Well, this is kind of like thesame as taking that million
dollar portfolio and generating5.1% per year.
Well, I've heard of somethingcalled the 4% rule, and the 4%
(09:22):
rule is kind of the maximum I'veheard I can take from my
portfolio without running therisk of running out of money
over the first 30 years or so ofretirement.
This is how the thinking goes.
So if you continue with thatthinking, you'd look at that and
say, okay, well, the annuity isguaranteeing a 5.1% withdrawal
rate.
Why would I take that guaranteewhen the alternative is to take
a lesser amount, aka 4%, fromthe lump sum?
(09:46):
And that leads some people toelecting the annuity.
Be careful here, that's not theright comparison.
Why?
Well, for a couple of differentreasons.
Number one when you look at thestructure and the assumptions
of the 4% rule, it's assumingyou're giving yourself a cost of
living adjustment by inflationevery single year.
(10:07):
So to use a round, simplenumber, if you have a million
dollars that you invest in yourportfolio and you take 4% the
first year, that's 40,000.
But you're not then taking40,000 in year one and two and
three and 10 and 20, you'reincreasing that number every
single year by inflation.
That's important to understandbecause with these pensions,
(10:28):
such as Mark's, for the mostpart, they're not paying cost of
living adjustments or they'renot providing cost of living
adjustments.
I should say so when you lookat the first year.
Sure, if you're comparing thisannuity option that Mark could
get to a 4% withdrawal rate fromthe lump sum, the annuity
option is going to look a lotmore attractive.
But take a look at this.
If we were to look at the 4%rule applied to the lump sum
(10:52):
that Mark is eligible for after10 years, the 4% rule has taken
his income from a startingamount of 40,848 in the first
year up to $53,300 at the end ofyear 10.
So you started with a lesseramount but you're building in
and I'm assuming 3% per yearinflation adjustments every
(11:12):
single year.
At the end of year 20, you'renow collecting $71,600 using the
4% rule, adjusting forinflation compared to the
annuity, which is still paying$52,200 per year.
And by the end of year 30, the4% rule would now have taken
your income up to $96,200compared to the annuity, which
(11:35):
is still paying $52,200 per year.
So that's the first error inthis thinking.
Now some people say well, james,that's a fine tradeoff to me.
I'd rather take more money upfront in the first few years
when I can travel and I'mhealthy and there's activities,
and then I'm okay with spendinga little bit less in my 80s or
90s.
Well, here's the thing the 4%rule isn't increasing so much as
(11:58):
the annuity payment isdecreasing.
You have to look at the realreturn.
The real return is what is yourportfolio doing after inflation
.
In other words, how is yourpurchasing power being
maintained?
So, under this 4% rule example,your purchasing power is
staying the same, even as thenominal amount of the income
(12:20):
you're taking from yourportfolio is increasing every
single year Versus the annuity.
Every single year, the nominalamount stays the same, but the
purchasing power decreases,called by 3% per year, if that's
what inflation is running at.
So, as you look at this, thefirst mistake of approaching it
this way is not accounting forthe cost of living adjustment.
(12:42):
The second reason this is a badcomparison and this is relevant
if you have a spouse or heirsyou want to leave money to is
the survivor options.
So if this is a single lifeannuity that we're looking at
and you die after one year ofcollecting your annuity payment,
the rest of your money justdisappears.
The rest of your money foldsinto the pension's general fund
and they're done, paying you Now.
(13:03):
Yes, you could do a joint andsurvivor benefit for your spouse
.
Now what that means is thatbenefit the mark outlined that
would last for both his lifetimeand his spouse's lifetime.
So if he died after one yearbut his spouse lived until age
30 or 30 years into retirement,spouse would continue collecting
those benefits for 30 years.
But it decreases the amountyou're eligible for in an
(13:24):
annuity.
So as you look at this, thebigger thing is if you have any
intention of leaving money tochildren or grandchildren or
heirs whoever it is the annuityreally doesn't do that.
It provides you a guaranteedincome for the rest of your life
and maybe the rest of yourspouse's life, but then it stops
If you compare that to takingthe lump sum.
(13:45):
So in Mark's case, if he tookthe million dollar lump sum, he
collected income for one yearand then he passed away, well,
there's still a substantialamount of money that would then
pass on to Mark's children orheirs or whoever would then be
collecting it.
So that's the second reason.
It's not a perfect apples toapples comparison of just
looking at the annuity and thencomparing that to what would
(14:05):
that look like if we were totake the lump sum and generate
that same level of income.
So if that's not how you run it, how should you do the analysis
?
This is really important tounderstand what you start by
understanding the imputed returnof the income annuity based
upon how long you might live.
What on earth does that mean?
What you should be doing, ifyou want to do the full analysis
(14:27):
on this, is you need to look atthis, because if you could tell
me exactly how long you live, Icould tell you pretty precisely
what your exact rate of returnis by taking that annuity.
Because here's what you have todo In Mark's case.
If he's going to elect theannuity option, he needs to look
at it like this.
He needs to look at it andessentially say I have a million
(14:48):
dollars in my possession.
I am going to invest that orexchange that into something
that's guaranteeing thesepayments for me for as long as I
live.
Now, what's the rate of returnon that?
Well, it depends on how longMark lives.
If Mark lives one year, therate of return is very poor.
Why is it a poor rate of return?
Because he's essentiallyexchanged a million dollars of
(15:11):
cash for payments, so for returnof principal of $52,200, and
then my investment's gone.
My investment's gone becauseMark passed, and so maybe Mark
doesn't care so much about thisas much as his heirs or spouse,
but that essentially translatesinto a negative 94.9% rate of
return.
Again, this is an interestingway to look at it.
(15:31):
Most people don't do this way,but it must be done this way.
What's essentially happened isMark invested in something that
generated a negative 94.9% rateof return, paid him $52,200, and
then the investment wasworthless, because once you pass
away, that pension iseffectively worthless.
So what you need to do is everysingle year.
(15:52):
So what if I live one year ortwo years or five years or 10
years?
And now you can build out anExcel spreadsheet and do this
there, and that's the best wayto do it, but what you're doing
is you're starting to get asense of okay, if I have a life
expectancy of 20 years or 30years or however long it might
be, what rate of return am Ieffectively getting by electing
this new option?
Let's take this a little bitfurther.
(16:12):
So if Mark lives for 10 yearsand now I'm using Mark's
specific numbers for this, notjust hypothetical but if Mark
lives for 10 years and then hepasses away, then that's the
equivalent of investing amillion bucks, receiving 10
annual payments of $52,200, andthen having nothing left.
So that would be the same astaking a million dollars in his
(16:33):
IRA, generating $52,200, andhaving a negative 10.6% rate of
return each year.
That would also effectivelyzero out his balance at the end
of those 10 years.
At the end of 20 years, mark'sreturn would be about 0.2%.
By electing the annuity option,that would be the equivalent
return when you look at what hisannuity payments would be
(16:55):
relative to what the lump sumwould be.
And at age 30 years it would beabout 3% per year.
Now one big disclaimer here Markalso has a supplemental annuity
that would pay from, I think,age 57 or whenever he retires
until 62.
That dollar amount's notfactored in here.
It would change these numbers,but just slightly, not a
(17:16):
significant increase, but justslightly.
But what I would be looking atis I would be saying okay, mark,
do you feel confident that ifyou live 20 years you could take
that lump sum and invest it anaverage greater than 0.2%
average return per year?
If the answer is yes, you'reprobably better off taking that
lump sum and growing it by morethan 0.2% per year, which is the
(17:39):
imputed return of what yourannuity is going to pay you.
If you think you're going tolive 30 years and if you think
that you could take a lump sumof a million bucks and invest it
at more than 3% per year, thenthat's probably going to be a
better option than taking theannuity payment that's going to
give you that annuity for longer.
But still the imputed return is3% per year.
(18:01):
The longer you live, thegreater that imputed return on
your investment, which justmakes sense.
The longer you return, or thelonger you live with an annuity,
the more payments you're goingto receive before that annuity
becomes worthless.
That annuity essentiallybecomes worthless once you've
passed away.
That's the first generalframework of how I think about
this.
When comparing options annuityversus lump sum what's going to
(18:24):
put the most money in my pocketover the course of retirement?
Some of it's guesswork.
We have no idea how long we'regoing to live, we have no idea
what the market's going toreturn, but when we can start to
frame it this way of okay, over30 years, could I outperform 3%
per year hurdle thatessentially becomes if I hit 3%,
I've broken, even based on whatthe annuity is going to be, the
annuity would have done for me.
(18:44):
If I could do better, thattells me.
Okay.
Maybe I want to explore optionsof taking the lump sum.
There's other considerations too, the first of which is just
risk.
Well, there's longevity riskthe longer you live, the greater
the value of that annuity.
There's also sequence of returnrisk.
So what if you retire and themarket just plummets those first
few years?
(19:05):
Well, the annuity, that wouldgive you consistent payments,
whereas the lump sum would bemore subject to that sequence of
return risk.
Now, side note, if you'reinvested the right way, you
should at least lessen that riskto a very significant extent,
but it still does exist.
There's also peace of mind.
Some people love the annuityoption because it's like they
(19:25):
never retired.
Well, it's like they retiredbecause they now have all day,
they have 40 hours a week, freedup to do what they want to do,
but it's like they're stillworking in the sense that
there's still a paycheck comingin and that just feels good.
One of the weirdest, oddesttransitions for people is going
from receiving a paycheck tocreating their own paycheck, and
so it's just easier sometimesfor people to say let me just
continue with this paycheck viathe annuity as opposed to coming
(19:49):
from my investments.
So those are some of theconsiderations.
Those are all very importantconsiderations and, mark, to
your question of how do I thinkabout that, that's how I would
think about that.
Now, here's the planning point.
I'm going to set those otherconsiderations aside for a
second, because there's a veryimportant planning point that
Mark and people like Mark arefacing right now.
That is, what should we do,james, given this analysis and
(20:13):
understanding, these numbers aresubject to change.
You know, james, it'd be onething if, okay, I work one more
year, or two more years andthree more years, and the lump
sum in the annuity payment, theyboth increase proportionately
because of the extra year ofservice.
But that's not what's happening.
In fact, it may even be theopposite the lump sum, as
interest rates are rising, aregoing to be decreasing while the
(20:35):
annuity payments are increasing.
So that analysis that we justran through, that was the
analysis for one specific yearof what if Mark retires.
Now what he needs to do is Markneeds to do another full
analysis on what would that looklike next year.
Because here's the takeaway forMark and people like Mark who
are in this position you need torun the numbers now.
(20:56):
And you need to run the numbersand you might need to guess at
what these numbers might be ifyou were to do the same thing
and retire next year or in twoyears or in three years.
Because if the annuity makessense, then working longer can
only increase that.
Now, barring any type ofarrangement or a thing where
your annuity is actually reducedbecause some type of pension
(21:18):
underfundment or whatever thecase might be barring any of
that.
Every extra year you work, yourannuity payment increases up to
a certain threshold.
So if Mark was already leaningtowards the annuity, then
working longer just makes thatleaning even more compelling.
Okay, that annuity is justbecoming higher and higher and
higher.
However, if Mark looks at thesenumbers and said you know what
(21:41):
the lump sum makes most sense,that's where the plan could
change pretty dramatically.
Because here's the issue.
Let's say and I don't have noidea what Mark makes in terms of
income, but I'm just going toassume he makes $150,000.
To illustrate a point realquick what if Mark works one
extra year before deciding toretire?
That's one more year of earning$150,000.
(22:02):
But what if, at the same time,mark's concern happens and his
concern is does the lump sum getcut by another 20%.
Well, 20% in this example is$200,000.
So, effectively, what Mark'sdone is he's traded one more
year of work to earn $150,000.
But the other, the downside ofthat, is he just lost $200,000
(22:24):
in the value of what his pensionlump sum is worth.
So you have to ask yourself isthat worth it to work one more
year and effectively get paid tonegative $50,000?
Probably not.
Now, maybe there's some otherbenefits that he's eligible for.
You know, sometimes, people, ifyou work long enough at a
certain company, you getlifetime medical benefits.
Or maybe there's otherfinancial benefits or other
(22:45):
factors that are also involved.
So, yes, look at the bigpicture.
But if we're just looking atthis of dollars earned versus
dollars given up because of thatpension decreasing as interest
rates have risen, then it's nota really compelling trade-off,
probably not one that Markreally wants to make.
So that's where you have tostart looking at trade-offs.
Does it make sense to leave thecompany now and find a job
(23:06):
elsewhere, even if that job paysless?
Because my guess is that job'spaying a lot more than negative
$50,000 per year.
Again, I just made thosenumbers up in terms of what
Mark's earning.
He would have to do theanalysis for his specific
scenario, but that's the way oflooking at it.
Or could he and maybe this is aunique planning thing you'd
have to talk to your HRdepartment.
Could you leave the company,take the lump sum and then
(23:29):
return to work in the same rolethat you were at before?
A lot of companies might not gofor that.
You might not be eligible forthe same pension benefits
continuing to accrue, but it'sat least one thing to consider.
And then again, look at the bigpicture.
Maybe staying longer makes youeligible for lifetime insurance
benefits.
Maybe staying longer thecompensation you're receiving is
greater than the decrease inpension you're taking or
(23:51):
accepting because of thoseinterest rate adjustments.
Also, I've been talking interms of Mark's pension.
Mark's pension is on thehealthier side compared to the
average pension most people willbe receiving.
If your pension benefit was, say, $100,000, in this case, well
then, a 20% reduction is $20,000.
Still significant, stillabsolutely significant.
(24:13):
But is that $20,000 reductionworth retiring a year early if
now you're giving up much moreincome in order to do so?
So look at this Are youcontinuing to have stock vest if
you stay longer?
Are there other benefits?
Are there other things that area benefit of staying.
Don't just go jump ship becauseyour pension lump sum balance is
going to be decreasing withinterest rates rising, but
(24:34):
absolutely look at planningpoints.
This is one of those thingsthat probably caught a lot of
people by surprise just theserising rates.
So make sure that as you'relooking at it, you're looking at
it holistically, but as we'vegone through this Mark.
First and foremost, thank youfor the question.
I hope this was helpful for youto see how I would unpack this.
But then for anyone who'sdeciding, what do I do here in
(24:55):
light of these changing pensionamounts that we'll be receiving,
so there's some considerationswe walk through, but then also
some planning points of giventhose considerations, what
should I now do for my specificsituation?
So I hope that was helpful.
Thank you, as always, foreveryone who's submitting
questions, submitting reviews,taking the time to tune in each
week.
Appreciate you all being here.
That's all I have for thisepisode.
(25:17):
Thank you for listening andI'll see you all next time.
Thank you for listening toanother episode of the Ready for
Retirement podcast.
If you want to see how rootfinancial can help you implement
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom andclick start here, where you can
schedule a call to one of ouradvisors.
We work with clients all overthe country and we love the
(25:37):
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember nothing wediscuss in this podcast is
intended to serve as advice.
You should always consult afinancial, legal or tax
professional who's familiar withyour unique circumstances
before making any financialdecisions.
Making the right decision about whether to
collect your pension as a lumpsum or as an annuity can be one
of the most important and themost difficult decisions to make
when it comes to yourretirement.
On top of this, the fact thatinterest rates are rising so
rapidly makes this an even morechallenging decision.
So in today's episode, we'regoing to go over an actual
example of how should you thinkabout this decision in the
context of your specific plan,so you can do what's best for
(00:22):
you.
This is another episode ofReady for Retirement.
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
Many of the episodes I do areevergreen to an extent, meaning
whether you listen to it in 2023or 2020 or 2030, a lot of the
(00:45):
principles will be the same.
And while many of theprinciples of today's episode
will be the same, it's verytimely to an extent, at least
for those of you who have sometype of a pension, and the type
of pension we'll be talkingabout today is really corporate
pensions, so private pensions,not a government pension that
just has different details abouthow it's run and the benefits
that you can get from it.
(01:05):
But the reason this is timelyis because interest rates are
rising.
Not only are they rising, butthey're rising rapidly.
Now, if you understand howpensions work, typically within
a corporate pension environment,you are given an option where,
if I were to work for a companyfor some number of years, they
might say James, we will pay you, let's say, $1,000 per month
for the rest of your life withthe annuity option for this
(01:27):
pension or if you don't want totake a monthly annuity, that's
guaranteed for the rest of yourlife, james will also give you
the option of taking a lump sumrollover of maybe $250,000.
I'm just making up some numbershere, and so that's an option
that's presented.
Here's the thing, though thelump sum option that $250,000 in
this example I made up thatnumber fluctuates based upon
(01:50):
where current interest rates are, and as interest rates rise,
typically the annuity company orthe pension company is going to
decrease the amount I'meligible for as a lump sum.
So even if the annuity staysthe same, so the monthly amount
of $1,000 per month, the lumpsum amount that I could get
instead typically decreases asinterest rates rise.
(02:12):
So that's why it's timely.
Interest rates haven't justrisen in the last 12 months 24
months but they've risen rapidlyand so this is causing a lot of
turmoil for people who havepensions as they're trying to
determine what's the best optionfor them.
So this episode is based upon alistener's question, and this
listener's name is Mark Marksays this he says love the
podcast.
(02:32):
I really appreciate the realworld use cases and the way you
cover things to consider, asthere's no one right answer that
covers all scenarios.
I am lucky enough to be part ofa pension program at a major
auto company.
My question is whatconsiderations and calculations
can you recommend to decidebetween taking a lump sum payout
or an annuity?
I've always leaned towards alump sum.
(02:53):
However, with rising interestrates, the 2023 lump sum amount
dropped by 20% and I expect the2024 amount to drop
significantly as well.
My goal is to retire in 2024 or2025.
The company sets new pensionrates each year based upon rates
in August.
Therefore, I may have to make adecision again this year to
retire early to grab a higherlump sum.
(03:14):
If I don't, I feel like I'mcommitting myself to taking the
annuity.
I would be 57 that year.
Some data on my pension If Iretired before November 30th of
2023, then I have two options,and those options are as follows
.
Option number one I could take alump sum of $1,021,200.
(03:34):
Or option number two, I couldcollect an annuity with a
lifetime payment of $4,351 permonth, with no cost of living
adjustment.
In addition to this, therewould be an interim supplement
of $950 per month between thetime I retire until I turn 62.
Marketing goes on to say if Iretire next May, the annuity
(03:55):
moves to a lifetime amount of$4,923, with a monthly
supplement of $2,134 until Iturn 62.
There's a big jump when I hit30 years of service.
Of course, I don't know thelump sum value for next May
until the new rates arepublished.
Based upon this year's rate,however, next year's lump sum
amount would be $1,194,267, butI suspect it might drop by 15 to
(04:21):
20% due to the rate increasesthat occurred since last August.
I will learn these new rates atthe end of September and I'm
looking for guidance on how tomake this decision on what
option to consider.
So that's Mark's question.
Mark, it is a good question andthere's a lot of details to it,
so let me unpack that realquick for all other listeners as
we look at these numbers.
(04:42):
Mark's in a good spot.
He has a healthy pension.
He can select either a called amillion dollars lump sum
payment or he could collect$4,351 per month as an annuity,
and that annuity would pay Markevery single month for as long
as he lives.
Here's the predicament Mark'sleaning towards the lump sum
payment, so leaning towards thatmillion dollars.
(05:02):
However, if he stays an extrayear, the annuity amount would
increase.
So if he were to collect theannuity amount instead, instead
of the lump sum, that's going togo up because that's based upon
years of service.
However, the lump sum amount,which is also based upon years
of service, also incorporatescurrent interest rates.
So he's asked himself am Igoing to be essentially working
(05:25):
against myself by continuing towork, because that might mean I
actually collect less of a lumpsum payment a year from now or
two years from now than I'd beeligible for if I went to retire
sooner than that.
So that's his predicament andthat's what we're going to
address in today's episode.
But before we do so, I want toquickly highlight the review of
the week.
This review comes from usernameAnne Ford Travel.
(05:46):
Anne Ford Travel gives apodcast Five Stars and says I'm
learning so much from James'sYouTube and podcast on
retirement.
He's an excellent communicatorand a thoughtful teacher.
His contents are full of greatinformation and thought
provoking insights, and alistener's podcast will drive
him to work gardening or doinghouse chores.
I am much more confident aboutpreparing for my retirement
because of James.
(06:06):
Thank you for being a greatteacher.
Well, anne Ford Travel, thankyou very much for that.
That's why I do this.
It's amazing to see all thefeedback that we get, so I'm so
happy to hear that this podcasthas helped you to feel more
confident in your retirement.
And for those of you who haveleft reviews, thank you very
much for doing so.
If you've not already done so,please take a moment and leave a
Five Star review if thispodcast has been helpful to you.
(06:28):
And with that, let's get on tothe episode.
So multiple considerations.
As with anything, there's veryrarely a right or wrong answer,
and very rarely does it justcome down to one single
consideration.
In this case, there'sconsiderations like maximizing
income, there's maximizing peaceof mind, there's understanding
longevity risk, there'sunderstanding tax implications.
(06:50):
So there's a lot to it.
But the first thing I'd want tolook at is, quite simply, which
option is going to maximizeincome?
What option is going to put themost money in your pocket at
the end of the day.
This is what Mark is askinghimself.
He's asking himself should Itake this million dollars as a
lump sum?
And, by the way, when you takeit as a lump sum, if you roll it
(07:13):
over to a traditional IRA, youavoid tax implications.
So you know some people rightaway.
They say, well, don't take thelump sum, there's a huge tax hit
.
Yes, there is if you take it ascash.
But in this case I'm going tomake in the assumption that he
rolls it over to an IRA, whichwould be a tax-free transaction.
So does he take the milliondollars as a lump sum or does he
take the $4,350 per month andcollect that as an income
(07:36):
annuity for the rest of his life?
Well, here's how you shouldn'tdo the analysis.
I'm starting with how youshouldn't do the analysis
because this is where mostpeople go to first.
Most people do this.
They would say, okay, well,mark is eligible for $4,351 per
month.
That equals $52,212 per year.
(07:57):
So Mark could get $52,212 peryear.
And we want to compare that towhat could the lump sum create
in monthly or annual income ifit had been rolled to an IRA
instead.
So the analysis would thencontinue.
Okay, if the lump sums$1,021,200.
And, by the way, quick sidenote, just because those numbers
(08:19):
are kind of long, I'm going toround the lump sum to a million
dollars.
I'm going to round the annuityto $4,350 per month.
The actual numbers I'm going tosay to you, or the analysis, is
going to be based upon the realnumbers.
But just to keep things simple,as you're trying to follow
along with these numbers, I'mgoing to use nice round numbers.
I think doing so might makeyour head hurt less as you're
(08:39):
trying to follow along.
Hey, everyone, it's me again forthe Disclaimer.
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
So let's do this.
If you take the 52,200 per year,which is what the monthly
(09:01):
annuity turns out to over 12months, and divide it by the
lump sum that Mark could receiveof about a million bucks, what
you come up with is 5.1%.
So what some people would sayis okay.
Well, this is kind of like thesame as taking that million
dollar portfolio and generating5.1% per year.
Well, I've heard of somethingcalled the 4% rule, and the 4%
(09:22):
rule is kind of the maximum I'veheard I can take from my
portfolio without running therisk of running out of money
over the first 30 years or so ofretirement.
This is how the thinking goes.
So if you continue with thatthinking, you'd look at that and
say, okay, well, the annuity isguaranteeing a 5.1% withdrawal
rate.
Why would I take that guaranteewhen the alternative is to take
a lesser amount, aka 4%, fromthe lump sum?
(09:46):
And that leads some people toelecting the annuity.
Be careful here, that's not theright comparison.
Why?
Well, for a couple of differentreasons.
Number one when you look at thestructure and the assumptions
of the 4% rule, it's assumingyou're giving yourself a cost of
living adjustment by inflationevery single year.
(10:07):
So to use a round, simplenumber, if you have a million
dollars that you invest in yourportfolio and you take 4% the
first year, that's 40,000.
But you're not then taking40,000 in year one and two and
three and 10 and 20, you'reincreasing that number every
single year by inflation.
That's important to understandbecause with these pensions,
(10:28):
such as Mark's, for the mostpart, they're not paying cost of
living adjustments or they'renot providing cost of living
adjustments.
I should say so when you lookat the first year.
Sure, if you're comparing thisannuity option that Mark could
get to a 4% withdrawal rate fromthe lump sum, the annuity
option is going to look a lotmore attractive.
But take a look at this.
If we were to look at the 4%rule applied to the lump sum
(10:52):
that Mark is eligible for after10 years, the 4% rule has taken
his income from a startingamount of 40,848 in the first
year up to $53,300 at the end ofyear 10.
So you started with a lesseramount but you're building in
and I'm assuming 3% per yearinflation adjustments every
(11:12):
single year.
At the end of year 20, you'renow collecting $71,600 using the
4% rule, adjusting forinflation compared to the
annuity, which is still paying$52,200 per year.
And by the end of year 30, the4% rule would now have taken
your income up to $96,200compared to the annuity, which
(11:35):
is still paying $52,200 per year.
So that's the first error inthis thinking.
Now some people say well, james,that's a fine tradeoff to me.
I'd rather take more money upfront in the first few years
when I can travel and I'mhealthy and there's activities,
and then I'm okay with spendinga little bit less in my 80s or
90s.
Well, here's the thing the 4%rule isn't increasing so much as
(11:58):
the annuity payment isdecreasing.
You have to look at the realreturn.
The real return is what is yourportfolio doing after inflation
.
In other words, how is yourpurchasing power being
maintained?
So, under this 4% rule example,your purchasing power is
staying the same, even as thenominal amount of the income
(12:20):
you're taking from yourportfolio is increasing every
single year Versus the annuity.
Every single year, the nominalamount stays the same, but the
purchasing power decreases,called by 3% per year, if that's
what inflation is running at.
So, as you look at this, thefirst mistake of approaching it
this way is not accounting forthe cost of living adjustment.
(12:42):
The second reason this is a badcomparison and this is relevant
if you have a spouse or heirsyou want to leave money to is
the survivor options.
So if this is a single lifeannuity that we're looking at
and you die after one year ofcollecting your annuity payment,
the rest of your money justdisappears.
The rest of your money foldsinto the pension's general fund
and they're done, paying you Now.
(13:03):
Yes, you could do a joint andsurvivor benefit for your spouse
.
Now what that means is thatbenefit the mark outlined that
would last for both his lifetimeand his spouse's lifetime.
So if he died after one yearbut his spouse lived until age
30 or 30 years into retirement,spouse would continue collecting
those benefits for 30 years.
But it decreases the amountyou're eligible for in an
(13:24):
annuity.
So as you look at this, thebigger thing is if you have any
intention of leaving money tochildren or grandchildren or
heirs whoever it is the annuityreally doesn't do that.
It provides you a guaranteedincome for the rest of your life
and maybe the rest of yourspouse's life, but then it stops
If you compare that to takingthe lump sum.
(13:45):
So in Mark's case, if he tookthe million dollar lump sum, he
collected income for one yearand then he passed away, well,
there's still a substantialamount of money that would then
pass on to Mark's children orheirs or whoever would then be
collecting it.
So that's the second reason.
It's not a perfect apples toapples comparison of just
looking at the annuity and thencomparing that to what would
(14:05):
that look like if we were totake the lump sum and generate
that same level of income.
So if that's not how you run it, how should you do the analysis
?
This is really important tounderstand what you start by
understanding the imputed returnof the income annuity based
upon how long you might live.
What on earth does that mean?
What you should be doing, ifyou want to do the full analysis
(14:27):
on this, is you need to look atthis, because if you could tell
me exactly how long you live, Icould tell you pretty precisely
what your exact rate of returnis by taking that annuity.
Because here's what you have todo In Mark's case.
If he's going to elect theannuity option, he needs to look
at it like this.
He needs to look at it andessentially say I have a million
(14:48):
dollars in my possession.
I am going to invest that orexchange that into something
that's guaranteeing thesepayments for me for as long as I
live.
Now, what's the rate of returnon that?
Well, it depends on how longMark lives.
If Mark lives one year, therate of return is very poor.
Why is it a poor rate of return?
Because he's essentiallyexchanged a million dollars of
(15:11):
cash for payments, so for returnof principal of $52,200, and
then my investment's gone.
My investment's gone becauseMark passed, and so maybe Mark
doesn't care so much about thisas much as his heirs or spouse,
but that essentially translatesinto a negative 94.9% rate of
return.
Again, this is an interestingway to look at it.
(15:31):
Most people don't do this way,but it must be done this way.
What's essentially happened isMark invested in something that
generated a negative 94.9% rateof return, paid him $52,200, and
then the investment wasworthless, because once you pass
away, that pension iseffectively worthless.
So what you need to do is everysingle year.
(15:52):
So what if I live one year ortwo years or five years or 10
years?
And now you can build out anExcel spreadsheet and do this
there, and that's the best wayto do it, but what you're doing
is you're starting to get asense of okay, if I have a life
expectancy of 20 years or 30years or however long it might
be, what rate of return am Ieffectively getting by electing
this new option?
Let's take this a little bitfurther.
(16:12):
So if Mark lives for 10 yearsand now I'm using Mark's
specific numbers for this, notjust hypothetical but if Mark
lives for 10 years and then hepasses away, then that's the
equivalent of investing amillion bucks, receiving 10
annual payments of $52,200, andthen having nothing left.
So that would be the same astaking a million dollars in his
(16:33):
IRA, generating $52,200, andhaving a negative 10.6% rate of
return each year.
That would also effectivelyzero out his balance at the end
of those 10 years.
At the end of 20 years, mark'sreturn would be about 0.2%.
By electing the annuity option,that would be the equivalent
return when you look at what hisannuity payments would be
(16:55):
relative to what the lump sumwould be.
And at age 30 years it would beabout 3% per year.
Now one big disclaimer here Markalso has a supplemental annuity
that would pay from, I think,age 57 or whenever he retires
until 62.
That dollar amount's notfactored in here.
It would change these numbers,but just slightly, not a
(17:16):
significant increase, but justslightly.
But what I would be looking atis I would be saying okay, mark,
do you feel confident that ifyou live 20 years you could take
that lump sum and invest it anaverage greater than 0.2%
average return per year?
If the answer is yes, you'reprobably better off taking that
lump sum and growing it by morethan 0.2% per year, which is the
(17:39):
imputed return of what yourannuity is going to pay you.
If you think you're going tolive 30 years and if you think
that you could take a lump sumof a million bucks and invest it
at more than 3% per year, thenthat's probably going to be a
better option than taking theannuity payment that's going to
give you that annuity for longer.
But still the imputed return is3% per year.
(18:01):
The longer you live, thegreater that imputed return on
your investment, which justmakes sense.
The longer you return, or thelonger you live with an annuity,
the more payments you're goingto receive before that annuity
becomes worthless.
That annuity essentiallybecomes worthless once you've
passed away.
That's the first generalframework of how I think about
this.
When comparing options annuityversus lump sum what's going to
(18:24):
put the most money in my pocketover the course of retirement?
Some of it's guesswork.
We have no idea how long we'regoing to live, we have no idea
what the market's going toreturn, but when we can start to
frame it this way of okay, over30 years, could I outperform 3%
per year hurdle thatessentially becomes if I hit 3%,
I've broken, even based on whatthe annuity is going to be, the
annuity would have done for me.
(18:44):
If I could do better, thattells me.
Okay.
Maybe I want to explore optionsof taking the lump sum.
There's other considerations too, the first of which is just
risk.
Well, there's longevity riskthe longer you live, the greater
the value of that annuity.
There's also sequence of returnrisk.
So what if you retire and themarket just plummets those first
few years?
(19:05):
Well, the annuity, that wouldgive you consistent payments,
whereas the lump sum would bemore subject to that sequence of
return risk.
Now, side note, if you'reinvested the right way, you
should at least lessen that riskto a very significant extent,
but it still does exist.
There's also peace of mind.
Some people love the annuityoption because it's like they
(19:25):
never retired.
Well, it's like they retiredbecause they now have all day,
they have 40 hours a week, freedup to do what they want to do,
but it's like they're stillworking in the sense that
there's still a paycheck comingin and that just feels good.
One of the weirdest, oddesttransitions for people is going
from receiving a paycheck tocreating their own paycheck, and
so it's just easier sometimesfor people to say let me just
continue with this paycheck viathe annuity as opposed to coming
(19:49):
from my investments.
So those are some of theconsiderations.
Those are all very importantconsiderations and, mark, to
your question of how do I thinkabout that, that's how I would
think about that.
Now, here's the planning point.
I'm going to set those otherconsiderations aside for a
second, because there's a veryimportant planning point that
Mark and people like Mark arefacing right now.
That is, what should we do,james, given this analysis and
(20:13):
understanding, these numbers aresubject to change.
You know, james, it'd be onething if, okay, I work one more
year, or two more years andthree more years, and the lump
sum in the annuity payment, theyboth increase proportionately
because of the extra year ofservice.
But that's not what's happening.
In fact, it may even be theopposite the lump sum, as
interest rates are rising, aregoing to be decreasing while the
(20:35):
annuity payments are increasing.
So that analysis that we justran through, that was the
analysis for one specific yearof what if Mark retires.
Now what he needs to do is Markneeds to do another full
analysis on what would that looklike next year.
Because here's the takeaway forMark and people like Mark who
are in this position you need torun the numbers now.
(20:56):
And you need to run the numbersand you might need to guess at
what these numbers might be ifyou were to do the same thing
and retire next year or in twoyears or in three years.
Because if the annuity makessense, then working longer can
only increase that.
Now, barring any type ofarrangement or a thing where
your annuity is actually reducedbecause some type of pension
(21:18):
underfundment or whatever thecase might be barring any of
that.
Every extra year you work, yourannuity payment increases up to
a certain threshold.
So if Mark was already leaningtowards the annuity, then
working longer just makes thatleaning even more compelling.
Okay, that annuity is justbecoming higher and higher and
higher.
However, if Mark looks at thesenumbers and said you know what
(21:41):
the lump sum makes most sense,that's where the plan could
change pretty dramatically.
Because here's the issue.
Let's say and I don't have noidea what Mark makes in terms of
income, but I'm just going toassume he makes $150,000.
To illustrate a point realquick what if Mark works one
extra year before deciding toretire?
That's one more year of earning$150,000.
(22:02):
But what if, at the same time,mark's concern happens and his
concern is does the lump sum getcut by another 20%.
Well, 20% in this example is$200,000.
So, effectively, what Mark'sdone is he's traded one more
year of work to earn $150,000.
But the other, the downside ofthat, is he just lost $200,000
(22:24):
in the value of what his pensionlump sum is worth.
So you have to ask yourself isthat worth it to work one more
year and effectively get paid tonegative $50,000?
Probably not.
Now, maybe there's some otherbenefits that he's eligible for.
You know, sometimes, people, ifyou work long enough at a
certain company, you getlifetime medical benefits.
Or maybe there's otherfinancial benefits or other
(22:45):
factors that are also involved.
So, yes, look at the bigpicture.
But if we're just looking atthis of dollars earned versus
dollars given up because of thatpension decreasing as interest
rates have risen, then it's nota really compelling trade-off,
probably not one that Markreally wants to make.
So that's where you have tostart looking at trade-offs.
Does it make sense to leave thecompany now and find a job
(23:06):
elsewhere, even if that job paysless?
Because my guess is that job'spaying a lot more than negative
$50,000 per year.
Again, I just made thosenumbers up in terms of what
Mark's earning.
He would have to do theanalysis for his specific
scenario, but that's the way oflooking at it.
Or could he and maybe this is aunique planning thing you'd
have to talk to your HRdepartment.
Could you leave the company,take the lump sum and then
(23:29):
return to work in the same rolethat you were at before?
A lot of companies might not gofor that.
You might not be eligible forthe same pension benefits
continuing to accrue, but it'sat least one thing to consider.
And then again, look at the bigpicture.
Maybe staying longer makes youeligible for lifetime insurance
benefits.
Maybe staying longer thecompensation you're receiving is
greater than the decrease inpension you're taking or
(23:51):
accepting because of thoseinterest rate adjustments.
Also, I've been talking interms of Mark's pension.
Mark's pension is on thehealthier side compared to the
average pension most people willbe receiving.
If your pension benefit was, say, $100,000, in this case, well
then, a 20% reduction is $20,000.
Still significant, stillabsolutely significant.
(24:13):
But is that $20,000 reductionworth retiring a year early if
now you're giving up much moreincome in order to do so?
So look at this Are youcontinuing to have stock vest if
you stay longer?
Are there other benefits?
Are there other things that area benefit of staying.
Don't just go jump ship becauseyour pension lump sum balance is
going to be decreasing withinterest rates rising, but
(24:34):
absolutely look at planningpoints.
This is one of those thingsthat probably caught a lot of
people by surprise just theserising rates.
So make sure that as you'relooking at it, you're looking at
it holistically, but as we'vegone through this Mark.
First and foremost, thank youfor the question.
I hope this was helpful for youto see how I would unpack this.
But then for anyone who'sdeciding, what do I do here in
(24:55):
light of these changing pensionamounts that we'll be receiving,
so there's some considerationswe walk through, but then also
some planning points of giventhose considerations, what
should I now do for my specificsituation?
So I hope that was helpful.
Thank you, as always, foreveryone who's submitting
questions, submitting reviews,taking the time to tune in each
week.
Appreciate you all being here.
That's all I have for thisepisode.
(25:17):
Thank you for listening andI'll see you all next time.
Thank you for listening toanother episode of the Ready for
Retirement podcast.
If you want to see how rootfinancial can help you implement
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom andclick start here, where you can
schedule a call to one of ouradvisors.
We work with clients all overthe country and we love the
(25:37):
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember nothing wediscuss in this podcast is
intended to serve as advice.
You should always consult afinancial, legal or tax
professional who's familiar withyour unique circumstances
before making any financialdecisions.
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