Pension FAQ: How To Determine If You Should Elect Lump Sum or Annuity

So I'm going to go through that today and I imagine , if four or five of you submitted that question on my website which , by the way , as you all know , you can go ahead and submit your question on my website If you'd like earlyretirementpodcastcom that there's a few more who did not submit a question . They're also probably thinking what should I do ?

So today I'm going to go through my analysis . If you have a pension , how should you think through taking the lump sum option versus the annuity option and really the framework behind exactly that . So I'm excited , I'm going to hop in . I'm going to change the format of the show a little bit .

If you've been listening for some time and you like it , are you going to screw it up on me ? I promise I'm not only trying to think of ways to improve , because I asked all of you hey , what do you want more of ?

And you guys said I want more case studies , I want more real life examples from current clients and I really want to make sure that I know exactly what I'm planning for with an early retirement , because there is , of course , a lot of nuance if you're going to retire before you're 65 and one never run out of money .

But number two , make sure you don't leave anything on the table . Most of you listening it's not . I don't know what a 401k is . It's . I know what it is . Help me optimize it so that don't leave anything on the table . So , if you don't already know , I have an ebook and we're going to get into the pension in just a second . I can't wait .

But the same time , I do want to go through this , which is every time I ask you guys to download my ebook . I'll say one , something that you're looking forward to never having to deal with again once you're retired . And I'm not telling you guys these responses just to scare you or say , oh my God , that's so sad , but it's .

These are real life examples from people who submit to download my ebook , so I'm going to tell you them , as well as go over the review of the week .

So the first one comes from someone who I'm always going to use a pseudonym , by the way , so I'm just going to call him John and his comment of something he's looking forward to never having to deal with again once he retires is never having to pull out my laptop to catch up on work after family has gone to bed .

So I don't know if that's something that resonates with all of you guys or just a few of you , but that is the one that I picked this week and the review of the week . I'm just pulling up on my phone , so sorry for the delay . Real quick , this one comes from GLDNBY5150 , who says awesome podcast for those looking to retire early .

My wife and I listen to Ari's podcast each week , so I imagine that's some dinner conversation If you guys talking Roth conversions and other things . Tons of useful information . You don't need to be an expert to understand it . I'm happy to hear . I've never heard a financial expert that advocates the benefits of an early retirement .

Usually you would like to use킨 tantrum Tell you how to do if you choose to , but it almost seems to be discouraged and it shouldn't be . It's attainable if you plan ahead . This podcast tells you how to do that . So thank you so much for that comment .

I appreciate it and you all probably know my joke , and a lot of you are in the health field who listen to this . But Don't be offended by what I'm about to say , but when I went to a doctor a few weeks ago actually a few months ago now , because I've given this example a few times I said hey , doc , I know that sounded great .

I think you think that sounded great . I have no idea what you just said . Okay , so talk to me like I'm five , and I didn't do it in a degrading way in any way , but I literally didn't know what he was talking about , and so oftentimes , when I'm interviewing new advisors to join our firm , I'll ask them to explain it to me like I'm five , five .

And if they use big words that I understand , but clients won't , then what good is it ? So I am glad that this is resonating . I do want you to go Wow , this makes perfect sense , like I'm worrying less about money because I understand how these things work . So , with all that being said , I'm going to hop into today's topic .

For some of you , this won't be a huge decision , because Everything doesn't rely on your pension decision , whether it's lump sum or annuity . Maybe you've got one or two or three or five million bucks and you just want to make sure you make the right decision with your pension regardless , so you don't leave anything on the table .

For others , it is everything where they don't have a ton of investments and whether they take that lump sum or annuity , it is really going to make or break their retirement planning . And especially if you want to retire early , there's nuance , as you can imagine . So I'm going to just go through an example .

As you guys know , that is my favorite way to learn . But before I go through the example , I'm going to give you just high level overview as to how I think through this .

So I'm going to give you an example , but once again , the high level overview is the following when you have a pension , you have an option , and there's interest rates and other things involved that we'll talk about but mainly , you have the option to say do I want to guarantee an income source for the rest of my life , do I want my spouse to have a

guaranteed income source or do I want to take a lump sum option ? And we have to ask ourselves what is going to put the most amount of dollars into our pocket at the end of the day , and that's really what you're asking yourself Now .

On top of that , there's what's called the financial answer and then the real life answer and more often than not the lump sum tends to make most sense If you're open to investing .

Well , if you're not open to investing a certain way , then more often than not it can make sense to take the guaranteed income option , also known as the annuity option , because you don't have to worry about what markets will do now . You have to worry about inflation and other things if you don't have a cost of living adjustment .

But you do have the ability to say you know what , I don't want to screw this up . I'm going to take the guaranteed income option . I know , god forbid , if something happens to me , my spouse would be okay or I just I'm going to elect the larger benefit for myself and if that go , if I pass away , it goes away . But I understand there's a risk there .

I'm okay with that because I don't want to invest a certain way . So that's the general framework . If you're just looking at , you know , 80 percent of people that I speak with , the lump sum option tends to make most sense . 20 percent of time the annuity makes most sense . But that's just so . You guys know I'm not married to one or the other .

Let's look at an example there to understand this . So this is a real client example that I'm going to walk through . And someone came to me and they said arie , I have the option I could take a lump sum balance of a million dollars from my pension , or I could take an annuity with a lifetime payment of $4,350 a month .

So we get these real life case studies that come to you . Probably all know my partner , james Kanol , by now , and if you don't , he is the president of Root Financial Partner . I'm the vice president , and we both don't take on too many new clients nowadays , but we are always training new advisors to be able to do the work that we talk about .

So if you are looking for guidance on all of these topics , it's , of course , what we love to do , so we'd be happy to help you all individually . But let's go through this . So this client came to us and they have a million bucks that's their option for the lump sum , or $4,350 a month . Now that $4,350 , that is a lifetime payment that they will receive .

And let's assume you know my name is Ari . As you all know , my partner's name is Alice , and so if anything happens to Ari , alice would still receive the same $4,350 a month . So this is called the joint and survivor option .

On your pension statement you might see there's a 75% option or a 100% option or a 50% option , and so the highest benefit , if you ever want to select the annuity , will always be the single life annuity . And what this means is maybe , instead of taking home $4,350 , you could take home $5,000 a month . But if you pass away , that goes away .

So God forbid anything tragic happens . But you elect the annuity option where you get guaranteed lifetime income , you collect $5,000 in a single month and then you pass away the rest of everything you've paid into with your working years . Of course , that just gets eliminated . That is gone forever . So that's a real risk .

So what a lot of times people like to do is say rather than take $5,000 a month guaranteed , I'm going to take this $4,350 a month . I'm going to take less of an amount , because if something happens to me , this will go to my partner and they will be able to get this the rest of their life .

So the assumption I'm going to make here is that you take the joint and survivor option , which for most people , that is what they are going to elect , if they do take the annuity option for your pension , and now we're going to go through this . You want to know what's going to put the most amount of money in your pocket . At the end of the day .

You could take guaranteed income or lump sum , and that lump sum can roll over and there's no tax implications . That can roll over into an IRA . So you don't want to just take the lump sum million dollars and put it into your bank account . You're going to see a really big , not so fun tax bill .

What you want to do is you want to take that million dollars and move it into an IRA no taxes , no implications at any kind . You can now just invest it however you want . So here's the analysis . The analysis is what's going to put more money into our pocket . So I'm going to go through that , but to start , it's here's how not to think about it .

Okay , I'm going to tell you , guys , there's tons of things to worry about financially . I don't want you to worry about a lot as well , and so what I mean by that is I'm going to tell you here's what to worry about , here's what not to worry about , because here's what I want you to not think about .

If you are thinking about this right now , no more worrying about the following Okay , so I know a weird way of saying it , but this person once again eligible for 4,350 a month . I know I'm kind of beating a dead horse here , but I want to make sure it resonates as an annuity for the rest of their life or a lump sum of a million dollars .

So here's how most people translate it . They go okay , 4,350 a month and I'm just doing this on my calculator with you guys right now that's about 52,200 a year . Let's call it 52,000 a year . So what's better ? Do I take 52,000 a year every single year , or do I take the lump sum annuity excuse me , the lump sum pension option ?

I know I'm even confusing you at this point the lump sum pension option and what's going to do better . Well , if we took a million dollars , some people say , ari , I've heard about this 4% rule , and so 4% of a million , that's about $40,000 . And that's less than the 52,000 I could create on a guaranteed basis .

So why on earth would I ever take this lump sum option ? Like that doesn't even make sense , and the reason that people look at this wrong is number one that 4% rule . That's not bad if you want to retire at the standard age of 65 and last till 95 and not invest well , but that 4% rule . The reality is you can do a whole lot better than that .

So if you invest well , you can reasonably take out between 5.2 to 5.6% of your portfolio and you won't run out of money for not 30 years , which is what the 4% rule is based on . But if you especially if you want to retire early , this other study was saying that you could take it out for 40 years .

So what this means is , as opposed to taking $40,000 out of a million dollar portfolio , you could take out between 52 and $56,000 if you invest the right way and follow a certain set of guidelines and you won't run out of money for 40 plus years . So that's a whole lot more applicable to an early retirement .

So , right off the bat there , if we invest well , we can take out between 52 to 56,000 a year versus the guaranteed income source of 52,000 years . So people go Ari , it seems pretty close here .

I know I could do maybe a little bit better with taking the lump sum option , but I'm not loving this lump sum because I could take a $52,000 guaranteed income source . The problem is there's no cost of living adjustment on this annuity . So what this means is that $52,000 , that's going to be $52,000 for the next 30 plus years .

So as long as you're living , you will get that $52,000 a year . The problem is the lump sum is growing , but the annuity option is not growing , so we have to always go . Okay , what if we got a little bit of growth on here ? Meaning , what if there was an inflation assumption ? And I'm not going to put anything crazy on here , but let's just look after .

Essentially , if we just use an inflation assumption of 3% , 3% , what would that 52,000 of guaranteed income really be worth ? So after 10 years , you've got 52,000 coming in from your guaranteed income source . It's still generating that and we have to ask ourselves what would be better . Well , is it taking that $52,000 ?

Or if we want the 4% rule , which I already told you . I don't even really love the 4% rule . But that 4% rule , after 10 years , if you took a million dollars , it could generate about $53,000 a year , so maybe 1,000 more . So some of you are going to already . What are they you just said ?

Here's what I just said Right away if you follow the 4% rule , we'll just use that for simplicity . You could take out $40,000 every single year of your million dollars .

And if you're investing and you're just investing alongside getting a good rate of return with an inflation assumption after 10 years you can't take out $40,000 , you can now take out about $53,000 . And so that 4% rule assumes an inflation assumption .

So it would take you 10 years if you elected the 4% rule option the kind of thinking here to be able to just about replicate the annuity . Okay , now , if we go out to 20 years , your guaranteed income , once again , it's still sending you $52,000 every single year , no matter what .

But now your lump sum million dollars would be able to create $70,000 of income . So that's $20,000 more dollars , and after 30 years your lump sum would be able to create $96,000 , not 52 . It's not quite double , but you're able to create a whole lot more income , and it's because you're investing the right way .

And so I try to avoid saying , hey , annuity , lump sum , one's better than the other , but more often than not we have to go okay , what's a real good comparison here ? Like , how do we think through this ? So here's what you need to think through before going through the real fun analysis how long are you going to live ?

None of us know , of course , but I don't want you to say , ari , I don't know how long I'm going to live , so I'm going to take the guaranteed income option .

And then you take the guaranteed income option , which is the annuity option , and then , god forbid , you pass five years later or 10 years later and now everything you've worked so hard for you don't really get a return on that , because now you've got some guaranteed income .

But if you would have passed away , there could have been $7,000 or $800,000 that would have gone to heirs . If you elected the lump sum option and that's a big thing we have to consider here there's a legacy play aspect to this .

If you take the guaranteed income annuity option and you die after five years but your partner keeps living , then they'll keep getting that income . So that's okay . But if both of you pass in 10 or 15 or 20 years , well , now you pass and that completely goes away .

Versus the lump sum option , maybe you're not as able to create as much income up front , but then if something happens to both of you , that can go to children or it can go to giving or it can do more for you . So the lump sum option more often than not tends to be able to create a whole lot more income .

I'm not saying it means you have to take one or the other . I'm saying you want to think through for you if there are any big health considerations that you need to think through . And then number two if you go , hey , I am open to investing . Well , let me do this analysis on my end to understand how I should think through this for my pension .

That's hopefully what I hope you all are understanding . Now , without getting into the weeds , I do what's called an internal rate of return analysis for my clients and I say where's the breakeven point , meaning if you were to invest instead of doing the annuity , how many years does it take for you to come out on top ?

And if it takes four years , well then , sometimes it's hey , this is a no brainer , we're taking the lump sum . If it takes 20 to 25 years , well then we're having a conversation and we're saying , okay , what other assets do you have ?

Because if you have other assets meaning you have other pension income or rental income or inheritance that's going to change whether you should take the lump sum or the guaranteed annuity . So hopefully you're able to see that . Of course , the answer is always it depends to all of this , but I want to make sure you're thinking through this right .

So here are the hard numbers with this example that I'm going to give you now that , hopefully , will get you out of the I don't know phase . And if you don't know the I don't know phase , I made this up but for all of you that know this already , apologies if you have to hear it again .

I am a soccer player and I love to play soccer and when I get hurt I'm not fun to be around . Okay , I joke with my clients that I'm worse than being hungry , hungry and angry and some of you are like all right , that's like really bad , like hangry is terrible .

I'm like I know I'm not fun to be around when I get hurt because I love playing soccer until I get my MRI and then I know the severity of my injury and then I have my physical therapy schedule . Then I'm good , I'm out of the I don't know phase . I'm now in the I know phase and I know what I need to do .

And a lot of you guys , probably in your head , are going hey , I just need to know what to do . Do I take the lump sum or the annuity ? And then how should I think through this ? So hopefully this is eliminating some of that . I don't know . So let's go through this example . You have to look at this through the annuity .

That's how I always go through it . What if you took the annuity versus what if you took the lump sum ? Of course , that's what we're going over now . So if you die and I know it sounds dark , but if you die after one year , in this example it's the equivalent of investing a million dollars , receiving one annual payment of $52,000 .

And then you have nothing . Why ? Because the money's gone after that . So you would be gone , assuming both you and your spouse pass away at the same time . Here , that's a negative 95% rate of return .

Okay , now if you were to live for 10 years and then pass away , it's the equivalent of investing a million dollars , receiving 10 payments of $52,000 every single year and then having $0 left . That's an imputed rate of return of negative 10.6% .

After 20 years , your imputed rate of return would be 0.2% and after 30 years your imputed rate of return would be 3% . So the longer you live , the greater the imputed rate of return is on your investment , and the reason for it is you're collecting more income for more years .

Now , to make it super simple , we have to ask ourselves do we think after one year we could outperform a negative 95% rate of return ? Well , yeah , that's pretty simple . You could just put it in a CD or a high yield money market and get 4.5% , 5% today . Now could you outperform 0.2% over 20 years ? Yeah , we probably can .

Could you outperform 3% over 30 years ? You probably can , and so because of that , in this example , the lump sum 99% of the time , is going to make more sense . Now we always have to once again understand do you have a bunch of other pre-tax assets I don't know about ? Do they have $2 million in a separate IRA or beneficiary IRA ?

Because if they do , we always want to make sure when we're looking at tax planning . Once again , if you retire early and you guys know my cauliflower example by now but you might have very low income and you can say that's amazing , I don't want to eat any vegetables .

Or you could say I'm open to eating a little bit of cauliflower today so I don't have to eat a whole bunch of cauliflower in the future and I know you guys are laughing some of you Right now . You'll send me clips and selfies of you guys with cauliflower . So it's getting out of hand at this point , guys , but it's still funny .

I still like receiving the photos . So I want to make sure you're thinking through this well . When your income is low , you can do creative tax planning . If you turn on this annuity , it doesn't give you a lot of flexibility to do things like Roth conversions that I talk about . So we always need to make sure we're thinking through this right Now .

That peace of mind comparison I didn't go through today , which is the annuity , it's not just some magical guarantee because there's no cost of living adjustment , but if your annuity option excuse me does have a cost of living adjustment , that's something we want to factor in , because if you're going to sleep a whole lot better knowing that you or your spouse is

going to have guaranteed income for the rest of their lives , you have to take that in consideration , which this imputed rate of return is not going to do . So I mentioned this early on , but I'm hiring a bunch of new advisors .

James and I are working on this as we grow the firm , and there's a lot of people coming to us who have awesome financial answers to my questions but less of the life answer to questions . So they'll look on paper and say , hey , this is a no brainer Like this person should take the lump sum .

What they don't know is that their spouse doesn't want to talk about finances at all and if something happened to them , you want to make sure that they have guaranteed income and don't have to worry about how are they going to create investments , especially if they don't want to work with an advisor or if there's something else at play there .

So it's the financial answer and the life answer , which I hope you guys are able to see . This was , once again , just kind of my overall assessment of how to think through this . Now , with interest rates , I'm just going to talk about this for a little bit and then I promise that's all I have on . Today's topic is if lump sum .

Here's how to think through it . Let me see it this way it would be one thing if the lump sum and annuity increased the same every year . Okay , that'd be very easy , but they don't . In fact , more often than not , they move in opposite directions . So when interest rates go up , your lump sum balance goes down . So what that means ?

Is that million dollars I just said earlier . If your lump sum decreases by 20% , maybe you don't have a million dollars anymore and you would have 800,000 dollars , and so now it's if it went down by 20% . I need to do the analysis again and I need to ask myself does it make sense ?

Do I work one more year so that interest rates are in a different spot , so when I collect the pension my balance is at a healthier spot ? Do I retire earlier before my interest rates that are high now decrease the value of my lump sum ? So you need to look at alternatives and , oddly , sometimes it makes sense to work one more year .

Sometimes it makes sense not to work one more year and actually retire earlier and elect the lump sum as you still have that higher value . So more nuance to this , of course , but hopefully this has been a helpful pension analysis for you guys , both for just quick on interest rates , but mainly lump sum versus annuity option with the pension .

How should I think through it ? So let me know , guys , if this was helpful . If , of course , you're going hey , I need a customer retirement plan . I need to think through what should I do here ? This is , of course , what we love to do . So if you have any questions , please do reach out to me .

You can apply to work with us In my description below , which you will see in the description , of course , this episode . So hopefully this was helpful for you guys and if it was , let me know . Thanks , guys , talk to you soon . 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 .

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