Ask MMD: Should I Do a Rollover, Pension Lump Sum or Annuity?

How do you know you’re a true financial geek?  The answer: You get excited when one of your friends asks you a money question because it means crunching some numbers with Excel!

Okay … maybe not to that extreme, but that’s pretty much how I felt recently for a friend who had a question about whether or not to cash out his pension with an old employer.  Here was his email:

So I attended a webinar today about the buyout (with my old employer).  Attached is a snip of the five options they gave us and what the amounts would be.

1. Rollover to an IRA or another employer’s plan = $33,165.41
2. Rollover to the old employer’s 401k plan = $33,165.41
3. Take a pension lump-sum cash payment = $23,215.79 (minus taxes)
4. Begin collecting monthly annuity payments for life starting now = $139.74
5. Begin collecting monthly annuity payments for life starting at Age 65 = $718.65

The cash-out option (No. 3) is on the table, but seeing as how it would mean losing quite a bit of money in taxes, it doesn’t seem like it would be really be enough to get out of debt or invest in something like a cottage.  However we might still go that route especially with our son needing a reasonable car in the near future…

Wow, that’s quite a bit of information to consider.  It actually reminds me of when my wife and I had to deal with a similar what-if scenario with her pension.  Or when one of my other friends had a question whether or not he should buy 5 years into his pension.

I’m not the only one who can sympathize with leaning towards Option 3 and wanting to use the money for things you need right now.  According to an article from the Boston Globe, nearly half of the people offered pension lump sums take them.

But as always with investments and taxes, things are never as they seem on the surface.  And if you’re not careful you might wind-up cheating yourself out of potentially thousands or even millions of dollars later on down the road.

So let’s walk our way through this problem and see which one ends up truly being the best one for my buddy’s future.   Readers: Any early guesses which one we’ll pick?

Numbers First, Then Decisions:

Before we do any sort of analysis whatsoever, I think the first thing to point out is the separation of emotion from analysis.

Right away I can already tell he’s thinking about all the things he could do with the money now: Pay off debt, the cottage, his son’s car, etc.  All of these things are perfectly fine, and they very well might end up trumping the analysis once we’re all done.  But you don’t really know until you know – what if we crunch the numbers and find out he’s really sitting on a potential million dollar pension plan?  (Not likely, but we don’t know yet …)

This is why I always strongly encourage people to crunch the numbers first and then make a decision.  Use reasonable assumptions and let the outcome speak for itself.  Then after that consider any qualitative factors that might further influence the end decision.

How Should We Tackle This Question?

Going back to our five options, I think the real question to ask ourselves is: How do each of these choices stack up against No. 5 – the future pension payments?

Basically if we do nothing, we already know that Option 5 is what will happen.  When he’s 65 years old, he’ll get a monthly check for $718.65 (or $8,623.80 per year) for the rest of his life.

So what we’ll want to do is investigate the four other options to see which ones give us more than $8,623.80 per year or greater.

Reasonable Assumptions:

• My friend is 40 years old. So we’ve got 25 years until he turns 65 and can start receiving his pension.
• His current tax bracket is 25%.
• We’ll assume any investments we make will be in funds that will yield an average compounded return of 8% annually (such as an index fund).
• According to the Social Security website, the life expectancy of a married man is 84.3 years (there’s a happy thought). So using that number, we really only need our money to last 19.3 years.
• Because the future pension in Option 5 is in absolute dollars, we will not be using inflation adjusted numbers. Plus that should make the example a little easier to follow along with.

Option 1 – The Rollover:

Using a simple FV (future value) equation in Excel, we find that $33,165.41 invested over 25 years will grow to $233,617.53.

So now assuming we go from $233,617.53 at age 65 and make equal annual withdraws all the way until the account is down to $0 at age 84, he could stand to withdraw as much as $24,159.73 per year.  That’s 2.8 times more than Option 5!

Now some of you might think that level of withdrawal is a bit too aggressive.  Remember we’re only trying to compare Apples to Apples since the pension will also be $0 after death.  But it would be worth it to consider having some money left over to cover his spouse and loved ones.  So even if we went with the more traditional 4% safe withdrawal rate, that’s still $9,340.65 per year … more than Option 5.

Option 2 – Keep It In Their 401k Plan:

The answer to this one is basically the same as Option 1: We’d end up with a portfolio where we could take out $24,159.73 per year.  But later on in the post we’ll add some other logic to this scenario that will make Option 1 or Option 2 seem better.

Option 3 – The Pension Lump Sum Cash-Out:

If we take the cash out now, we’d have to pay taxes up-front this year.  That means the immediate $23,215.79 buyout would really drop down to $17,411.84 once we hand over 25% to the tax-man.

Now let’s assume instead of purchasing something with that money, we invest it in a regular index fund and let it grow for 25 years.  The future value would be $122,649.12 by age 65.  And similar to the way we handled Option 1, that would give us $12,683.85 per year throughout retirement.

That’s more than Option 5, but only half as good as Option 1 or 2.

Option 4 – Annuity Payments Now:

Just like with the Lump Sum Cash Out option, if we started receiving annuity payments now, we’d have to start paying taxes on them each and every year.  That means our $139.74 per month (or $1,676.88 per year) would really drop down to $1,257.66 per year after 25% goes away to taxes.

So what does $1,257.66 look like after 25 years? It has the potential to grow to $95,016.20, and that would give us $9,826.17 per year we could take out.  But wait!  We also will keep receiving that $1,257.66 annuity payment.  So really the grand total is $11,083.83 per year for retirement.

That’s really close to Option 3, more than Option 5, but still not anywhere as high as Option 1 or 2.

So What’s the Best Option?

In my opinion Options 1 and 2 will yield the greatest potential for the most money at retirement.  And personally between the two, I like Option 1 the best.  If it were me, I would just take the balance and roll it all over into a low-cost IRA.

Not that 401k plans are bad, but all things being equal I usually find the IRA to be the better choice because they are:

• It’s cheaper
• Generally have better performing investment options
• You’ll get more control over the account

Now Consider Your Other Stipulations:

Now that we have some reasonable estimates as to what each of these five options will amount to in the future, it’s okay to go back and ask ourselves if our present needs outweigh the delayed gratification.

In this story my friend could have easily been laden with high-interest debt or medical bills or some other disaster, and that could have greatly impacted our final decision.

Thankfully that’s not the case!  So really what we’re ultimately saying is are any of those options worth giving up a potential $233,617.11 in the future?  For me, I know I’d just stick with Option 1 and keeping the money ear-marked for retirement someday.

Readers – What about you?  Without doing the math, would you have gone for the rollover, pension lump sum or annuity payments?  How would you have approached this problem differently?

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