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AS THEY APPROACH retirement age, workers sometimes get to choose between a monthly pension and a lump-sum payout. It’s a choice I recently made—one I researched carefully. In the end, I made an unusual decision that took a few extra steps.
Let me start at the beginning. In 1984, I began working for American National Insurance Company as an investment analyst. I left the company in 1991, but still qualified for a small pension. Now, at age 62, I was offered three choices. I could receive a monthly pension of approximately $300 starting at 65, or I could take the pension earlier and receive a smaller monthly benefit, or I could take a lump sum of nearly $50,000.
To start, I wanted to know if one offer was considerably more valuable than the others. To compare, I went to a website that provides quotes for immediate annuities. It turns out my company pension would pay more each month than an immediate annuity I could buy for $50,000, but not a lot more.
Still, having an additional stream of monthly income sounded appealing. But there were other considerations. I’m already getting a larger monthly pension payment from another insurance company—Union Central, now part of Ameritas Life—where I worked from 1999 to 2015.
I also plan to take Social Security at age 70, which will give me a healthy stream of inflation-indexed income. Finally, I’ve purchased three deferred-income annuities that will begin paying me income starting at ages 76, 80 and 85, respectively. Should I live until 85, I’ll be receiving guaranteed income from five different sources.
Viewed from this perspective, another payment of less than $300 a month started to seem less significant. Besides, my old employer had announced it’ll be acquired by another company. I didn’t want to monitor a small pension from a company that wasn’t my prior employer.
That’s when I decided to take the lump-sum payment. My planning, however, wasn’t done. Instead of receiving the lump sum directly, I opted to have my old employer deposit a tax-deferred payment into my IRA. Why? I wanted to convert that money to a Roth IRA while I still had time to avoid a potential extra expense.
What extra expense? Like most retirees, I’ll be eligible for Medicare at age 65, which is just over two years away. Medicare Part B and Part D premiums are higher if you have a high taxable income. But Medicare’s income lookback period is two years, which meant that I could convert the $50,000 to a Roth IRA without facing higher Medicare premiums—but only if I was quick about it and did the conversion this year.
There was one further wrinkle. The stock market had recently declined, so I converted $50,000 and immediately put the money in stocks. If the stocks rebound, the gains will be tax-free. How will I pay the tax owed on the Roth conversion? I realized a hefty long-term capital gain. I’ll use that money to pay the conversion tax bill.
James McGlynn, CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. Check out his earlier articles.
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My wife had a very small pension that offered the same choices. We went with the pension because it will pay for her lifetime and my guess is she’ll live to 100+ (family history, good genes, exercises, eats healthy, etc.). The pension is small and will be worth a lot less in 35+ years but it’s a very, very small part of her retirement income and will not affect her standard of living at all. It’s nice to have a mix of income.
I was given this decision by AT&T and took the lump sum for two reasons. First was the difference in cash flow as mentioned. But more important, I did not and still do not trust AT&T’s management to deal fairly with the pension plan.
I faced a similar choice when I retired after 40+ years in the investment business. What I decided to do was take the two small pensions as joint and several annuities, but take the much larger retirement from my final employer as a lump sum and roll it into an IRA. The investment returns in the years since I retired have more than justified this strategy. As the old saying goes, however, “past returns are not a guarantee of future returns.”
Another factor when making this decision is if your heirs will be able to inherit/receive your pension benefits should you unexpectedly die before you start collecting them. Heirs will likely receive greatly reduced pension benefits after an untimely early death.
Also stock market returns are likely to exceed the expected actuarial rate of return set by the pension – thereby making the lump sum invested in the stock market more attractive than retaining the pension. In our case the projected pension rate of return was set by the Pension Benefit Guaranty Corporation based on a historical US corporate bond rate. While the historical US corporate bond rate the Pension Benefit Guaranty Corporation employs was VERY generous given the current interest rate environment, it was well below historical stock market returns.
To add to this thorough thinking, here’s one other consideration that could apply to some folks. We ideally would keep taxable income to a minimum in the first few years of retirement so we can realize some capital gains at a 0% tax rate. Receiving a pension in monthly payments could make it difficult to keep taxable income at a level low enough to do this in any significant way. I wrote about this more here
I have been evaluating the same question. Another approach that I used was to determine the rate of return the lump sum would need to generate to match the monthly payments over my life expectancy. I found the monthly payments offered the more attractive options.
I’ll echo everyone else’s sentiments Mr. McGlynn. Very well thought out. I remember your article last year (June-ish 2020, I believe) where you laid out how you’ve laddered your QLACs and such. Opened up a world I didn’t know about at the time. Kind of like building a fortress around your latter years. Highly recommend giving it a read. Thanks
Thanks Matthew. I am surprised that QLAC’s haven’t become more popularized. The low yields aren’t helpful.
Well written and well thought out article James. My wife had a similar decision some years ago. We discussed it and she chose to roll it over to her IRA. I wish I had been smarter about Roth conversions at the time.