Pension Settlement Decisions
Think twice before accepting a commutation offer (getting a lump settlement instead of lifelong income) from a pension. There are four considerations here.
- Should you give up the guaranteed lifelong income? In most cases, the income is insured by the Pension Benefit Guarantee Corporation, analogous to the FDIC for bank accounts. The coverage level is subject to changes in federal law, but currently even large pensions are fully insured. Once received, the lump settlement is obviously not.
- Can an annuity from at least an A– rated carrier guarantee a greater income than the pension plan itself? This is a simple shopping procedure in which you take the commutation number on the plan statement and have an independent broker shop for you. Be sure to compare apples to apples, though: Match the income settlement option you want from the pension with the same income option for the annuity (e.g., one-life-only pension compared to an annuity’s life-only payout; 100% joint-and-survivor pension compared to the joint-and-survivor payout on an annuity). These numbers are quite straightforward; if the carrier cannot beat the pension, keep the pension. One caveat: Compare the income from an immediate annuity starting the same month as the pension would. If deferring a year (commonly required for the best-payout annuities), you must adjust for this fact. If the annuity requires holding the premium a year before payout begins, then you will miss one year of income. One could subtract that from the lifetime total income, but the best method is to have the representative or planner discount both cash flows to a present value.
- Your spouse’s need for income after you die: If a health condition creates a heightened risk of untimely death, you definitely want to keep the pension, reducing it to obtain its Survivor Benefit Payment (SBP). This is because that payment is a payment for the life of the spouse contingent upon your death (i.e., it is life insurance and you cannot obtain an adequately priced alternative in this health scenario).
- What if the pension pays a Cost of Living Adjustment (COLA)? First, no pension guarantees that, but many have a history of the trustees approving some increases. If so, it is more likely that the annuity will not be competitive with the pension, unless the annuity has a guaranteed annual income increase of 2–3%, or by formula. That would make the annuity more attractive because even the pension will never guarantee a COLA. Variable annuities, when annuitized as variable payouts, will likely beat pensions eventually, but there are too many “moving parts” to be sure. Variable annuities start with a very low payout, but this adjusts as the underlying annuity units (think stocks but not exactly) change in value as the market rises and falls (yes, income can decline). A handful of EIAs have the potential to increase income even though they guarantee a fixed income. These EIAs are those that continue to compare your cash value to the income account value that was determined at the point when you start income. If your withdrawals are less than the interest credited because of the index growing strongly, then your income will ratchet up. This is unlikely, however: the withdrawal rate is around 5% and the interest crediting methods are unlikely to give you that much interest. The index would have to increase by at least 10% to get you 5% interest credited.
Income Needs Should Drive Your Product and Account-Type Mix
Keep in mind that your money is earmarked for various purposes, even if some accounts are versatile. Your top priority in planning should be to have surety for at least enough income to pay for necessary items, those expenses you are guaranteed to have to pay. This necessary match-up of guaranteed income to guaranteed-to-incur expenses is why annuities are not just for nonqualified money.
You might trim some expenses to avoid selling off shares cheap in a downturn, ending up with fewer shares to participate in an upswing. There are basically two types of investments, guaranteed and not guaranteed. Wouldn’t it be wise to total all your “guaranteed-to-pay-out” expenses and fund income vehicles that have a commensurately guaranteed ability to pay for these? This is how you solve for the minimum to put into an annuity for income (you cannot get adequate income from CDs or savings accounts, for example, and stocks and bonds can lose substantial value). Look at the budget you made and kept up. Compare these necessities to the totals of your pension(s) and Social Security. If your guaranteed income cannot cover all of your guaranteed expenses, then you must get an annuity to cover the remainder—at least if you are prudent and want to avoid exhausting income sources one day!
Have your advisor apply a realistic inflation rate to these necessities, from realty taxes to medical expenses. Studies have found that the total basket of necessities, despite including medical expense, inflates about a point slower than the “market basket” that composes the Consumer Price Index (CPI). That’s because most demand is directed by younger people at items they buy and seniors buy less of.
There are two ways to address the effect of inflation on your expenses when calculating your minimum annuity need. If your investment portfolio is large enough, earmark it to cover your non-essential income needs, plus that part of your necessities that inflate. Then, obtain a Monte Carlo model of your portfolio to determine whether it will sustain this growing expense in your budget. Implement the asset allocation that gives you at least a 90% likelihood of not exhausting your assets should you reach age 95. Don’t take chances on this! Adjust your budget if you see a severe deficit; your likelihood of success is below 90%. Model in the annuity (reduced at-risk portfolio, increased guaranteed assets due to deposit to the annuity). This should increase your likelihood of success because it will enable the model to keep your necessary expenses paid and it will cause less to be drawn from your at-risk portfolio. If the simulation results are still under a 90% likelihood of success, you must adjust your budget or increase the volatility that you are willing to accept in your at-risk portfolio. Use only models that adjust the portfolio risk level down as the years progress, because you know you must reduce risk as you become more dependent upon the at-risk portfolio.
The model allows for “what-ifs” like a long-term care stay. If this crashes the portfolio (Monte Carlo at 50% or less), then you would be prudent to get LTC coverage of at least $200/day with an inflation rider. This then reduces your portfolio or perhaps causes you to exchange a high cash value life policy for a life or annuity policy that offers LTC coverage. The model is rerun to check for exhausting the portfolio, and these iterations of problem identification and solving continue. Again, if the Monte Carlo simulation dips below 90% and you’ve covered all of these bases and maxed out of acceptable risk level for the portfolio, then you absolutely must keep working, spend less, or convert your home to income (sale/reinvest or reverse mortgage). Tax efficiency must be checked with every change, by the way.
Can you see now why this sort of analysis is a must? If you do not do this, you might be blindly setting yourself up for exhausting assets or income sources before you die!
Back to Basics
Have the advisor calculate how much income you need to pay your necessities, not considering inflation. The amount needed to generate this “necessity” income stream is the minimum you should place in an annuity. This must be modeled and then shopped for because the amount is different for everyone and you will not want to place most of your portfolio in an annuity (they are less liquid with lower returns than a well-managed portfolio). Yes, your best return—and you are still a long-term investor at retirement—is in a well-managed, efficient-frontier portfolio of stocks, bonds, etc. as discussed previously. You have to adjust your draw from the at-risk portfolio, however, when there are market losses. Some people prefer the security of annuities and invest above this minimum amount calculated to produce income for necessities. Fine, but the government will not allow any agent to place more than about half your investable assets in annuities anyway.
The other way is similar to the above, but you and your advisor inflate the “necessities.” You or your advisor derive a projected budget for the necessities part of your expenditures; inflate this at about 2% annually for at least thirty years of retirement life. Next, have your advisor find a fixed payout annuity that covers most of this expense stream. This annuity might offer an inflation rider, though these are disappearing from the market. The main way to consider inflation in necessities and match this to a fixed annuity is for you to buy three. One gets an amount that would pay all your necessary expenses and a tad more. The second does the same, but gets less of a deposit because its income is “turned on” about ten years later in order to produce the extra needed to cover the inflation in those necessities. The third likewise kicks in twenty years hence.
The point is that prudence dictates that you split your portfolio to cover guaranteed expenses with guaranteed income. Cover optional budget items and possibly inflation with your at-risk but usually higher earning equities/bond/realty/other portfolio.
We covered asset allocation and Monte Carlo support previously. If you invest over many years in retirement, your best rate of return will not be from an annuity, but from an efficient portfolio. Again, rebalance at least quarterly.
Next, let’s look at guaranteed income in more detail.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
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