There’s a game that both kids and adults play – the “would you rather” game. As in, would you rather have all the money in the world or be able to fly, Superman-style, as my seven-year-old Jake asked me just the other day.
And when I was recently at a Clark Howard Christmas Kids event, someone asked our group a “would you rather question.” This time, it was whether we’d choose to have ten times our salary with double the stress, or 20% more in pay and half the stress.
I want to talk about a real-life version of “would you rather.” This one has the potential to have a serious impact on your retirement and financial wellness. And, as is always the case with this question, the answer isn’t clear cut and obvious.
Would you rather take a monthly pension benefit amount that’s guaranteed for life or a lump sum buyout offer?
This question is timely. Over the last several years, we’ve seen pension buyouts happen at big-name corporations like Coca-Cola, FedEx, Verizon and Ford. The most recent addition to the list is General Electric. The company announced they’ll offer over 100,000 retired or soon-to-be-retired workers the option of a lump sum over their monthly pension benefit.
So, what’s the better deal – a steady stream of income for life for you or you and your spouse, or one big, juicy check handed over to you?
The devil is in the details; it matters how much the lump sum offer is and how much you could expect from your monthly benefit.
This is where the 6% Test comes into play. To use this test, take your monthly pension offer and multiply it by 12. Then, divide that number by your lump-sum offer.
If the result is 6% or more, then you may want to go for the monthly payment. If the number is below 6%, then you could do as well (or better) by taking the lump sum and investing it (perhaps by rolling it over into an IRA) and then paying yourself each year. In this scenario, you’re effectively creating your own pension.
Here’s the rule in action. Imagine that your monthly single pension amount is $2500, and you’re offered a $500,000 lump sum buyout. Take $2500, multiply it by 12, and divide it by $500,000. Our percentage, in this case, is 5.4%. In this example, based on the 6% test, you should consider taking the lump sum.
But there’s yet another wrinkle to throw into the mix: Should you take out a life insurance policy to replace the lost lump sum lost from your pension to protect your spouse and your estate?
This is a forever circular debate. And the “would you rather” question of monthly benefit versus a pension buyout is not the kind of decision that can be an “always” or “never” answer.
As an example of how difficult this decision can be, let’s take a closer look at one of the more nuanced pieces of this question that some folks have to answer.
What if your pension is $5,000 per month ($60,000 annually) for you, $4,200 per month ($50,400 annually) if you include your spouse, or a $1.0 million lump sum? Which would you rather have? Would a life insurance policy be a good idea here?
Let’s do the math to find out.
The difference between your pension and the shared pension is $800 per month or $9,600 per year. Could you buy a life insurance policy to replace the lost lump sum if you were to die somewhere between a year and ten years later? The answer is likely yes if you’re healthy. I recently priced a 20-year level term life policy for a healthy 59-year-old for this very illustration. The premiums ranged from between $375 to $540 per month or $4,500 to $6,500 per year.
If you decided to take out the policy to protect your spouse and take the single pension amount, you’d have $5,000 in monthly income minus, say, $400 for the insurance, leaving you with $4,600 each month. That’s better than the shared pension amount of $4,200 by $400! So, as you can see, this choice could give you the best of both worlds.
But the big catch is this – what if you live longer than the 20-year term? Then, all of those insurance payments were for naught. But, over the 20 years, you would have collected a total of $1.2 million in pension benefits.
My thoughts on this scenario are these. First of all, it’s excellent that you hedged yourself and got $1,200,000 over 20 years while protecting the lump sum for your spouse over the same time. But this hypothetical makes me ask, “What if you had taken the $1.0 million, invested it, and taken an income of $60,000 per year?”
Likely you would still have a similar amount of retirement assets. You’d be pulling 6% out of your portfolio annually, and, on a balanced portfolio, your earnings should be able to get you close to this withdrawal rate. Sure, a bad run for stocks and low-interest rates on bonds could mean you take a hit. But, historically, a balanced portfolio of say 50% stocks and 50% in bonds would earn that level of income. So, after 20 years, you may very well still have $1.0 million despite your yearly withdrawals. You could have a little less, but you could also have even more.
This is my bottom line on life insurance policy replacements of lump-sum offers – I don’t like how the math works. It seems like they’re typically a wash in monthly income, and twenty (or twenty-five) years is a short period where you’ll likely run out the insurance coverage.
My advice is to run the 6% Test on the pension benefit offered for you and your spouse and see where you land.
None of us know what the future holds. What this conversation does remind me of is that there are advantages to both choices. There’s the “bird in hand” aspect of the lump sum asset. I think if there is a real answer to our question, it leans more toward taking the lump sum and investing it, earning income and effectively creating your own pension.
But, on the other hand, the security and stability of the monthly pension can also be appealing. It could serve as a portion of your income picture. You want it to be but one of your income streams – remember that the happiest retirees have three. If you can swing having your pension make up one-third of your total retirement income pie, then all the better. This would be the ideal situation, with your liquid assets making up the other two-thirds. In this case, you could garner added peace of mind, income diversification and less stress on your portfolio.
There’s a lot to consider when it comes to the “would you rather” question of a monthly pension versus a lump sum. Remember, the first step should always be to approach the issue rationally, i.e., by doing the math. See if the monthly pension passes the 6% Test. Beyond that, consider how other variables (like the ones we mentioned above) tip the scales towards your unique answer.
And as for my answer to my son Jake’s question? That one was a no-brainer for me. I’d choose Superman flight!
