When we’re fortunate enough to have some rare downtime, many of us probably spend a few minutes flipping through the innumerable cable channels with the off-chance we’ll come across one of our favorite movies. We all have that list of personal favorites that, regardless of the point at which we pick up the story, we’ll sit and watch to the conclusion, no matter how late we have to stay up. For me, a few that come to mind are: Gladiator, The Fugitive, Cinderella Man, Jaws and The Godfather (I and II, but certainly not III).
Another movie I came across recently was the 1971 classic “Dirty Harry” starting Clint Eastwood and its famous scene brought to mind an important financial planning question (I know, I need to get out more). In the film, it struck me that Clint Eastwood utters what I think is a great starting-point question for those future retirees with a pension who are facing the big question of whether to take a monthly payout or a lump sum.
So the Dirty Harry Question to retirees is: “Do you feel lucky?” or in retirement planning terms: “Do you feel confident in your longevity AND your ability to invest wisely?”
While that may be a simple question, the decision is actually quite complex as the retiree has to consider a number of factors in order to make the call. In my opinion however, the decision starts with whether or not you are comfortable taking on the responsibility of managing what could be a substantial sum of money. So let’s run through a list of questions and issues you must address with your employer and you must ask yourself when considering which option to take.
Before we get to the questions we must first start buy figuring out the “return” of the monthly payment on the lump sum and compare that to estimated market returns. This can be calculated by annualizing the monthly payment (let’s say $1,000 / month x 12) and dividing it by the lump-sum option, let’s say its $200,000. So $12,000 / year / $200,000 is 6%. Not a bad “income stream” return in today’s world of low interest rates. Do you think you could do better? In addition, we have to evaluate many other factors keeping this 6% in mind.
So we have to answer the “Dirty Harry Question”, followed by a series of other important questions. (DISCLAIMER: These questions are general guidelines only as every plan and every personal circumstance is unique. You should consider contacting me, a CPA or an attorney to break down the details of your plan and your situation.)
So the Dirty Harry Question is:
- Can you reasonably expect to out-live what is the “normal” life expectancy actuarial tables (a good start is http://www.socialsecurity.gov/oact/population/longevity.html) AND do you think you can “beat” the return on average over this time period (e.g. better than 6% cited above)? If “yes”: Advantage – Lump Sum. *** Keep in mind: Your investment on the lump sum could compound which could be a BIG advantage to the lump sum. These calculations can get involved but I am more than happy to help with this project. ***
Once you answer the Dirty Harry Question, you also need to consider other questions that could sway your decision. They are:
- Inflation Adjustment: Is the monthly payment adjusted for inflation every year? This is rare but if so, this is a big plus as your income stream could grow (in line with some inflation index) every year, effectively buffering your purchasing power from the deteriorating effects of inflation. If “yes”: Advantage – Monthly Payment
- Survivor Benefit: Does your surviving spouse continue to get a payment after you pass away? This answer here should be obvious but in reality you’ll likely have to take a lower payment while you’re alive in exchange for your spouse continuing to get payments after your demise. If “yes” we could do some additional computations, but in general: If “yes”: Advantage: Monthly Payment.
- Solvency of your Company: Is there even a small chance your Company could default on their payments or will they make good on your monthly payment? If you are extremely confident payments will be made then “yes”: Advantage – Monthly Payment. This is especially precarious. I must emphasize, if there’s even a small chance the company defaults (or scales back the payment) you should seriously consider the lump sum.
- Your Living Expenses: Are your essential living expenses already covered by another source of “guaranteed” payment like Social Security and the interest/dividends from the rest of your portfolio? If they are, then you can probably afford to take a little more risk and invest the money yourself. If not, and the pension payment would be essential to your basic living expenses, you cannot afford to take the risk with them. So are your living expenses already covered: If “yes”: Advantage – Lump Sum
- Your Legacy: Do you want to leave a larger inheritance to your heirs (AND your living expenses are covered by other income streams)? If “yes”: Advantage – Lump Sum. Taking the lump sum and investing it wisely will usually yield some remaining funds for your heirs. In most pension plans, the payments stop upon your death and / or the death of your spouse.
- Protection from Creditors: Typically, a lump sum transferred to a tax deferred retirement account (e.g. an IRA) is likely to be subject to creditors should you need to file for bankruptcy. A tool to help address this (and other issues) would be a trust, which would require the services of an experienced estate planning attorney. Do you want to eliminate the risk of subjecting your funds to creditors? If “yes”: Advantage – Monthly Payment.
In the end, we can’t know the future so we have to make an educated guess based on both the knowable facts (payout vs. lump sum, inflation adjustment, investment options, etc.) and educated assumptions (expected life span, reasonable market returns, etc.).
So again the first question is: Can you reasonably expect to live at or beyond the “normal” life expectancy and if so, can you reasonably expect to achieve a solid return by investing yourself? Or if Dirty Harry were your financial planner he might ask: “Do you feel lucky?”