In a nutshell
In this blog I address the “annuity or lump sum?” and the “if, when and how much to annuitize?” questions with a discussion of the pros, cons and other qualitative considerations that go into this very personal decision.
“Annuity or Lump-sum?” One could very simply just take the annuity option (“status quo bias” in behavioural finance) since these pension assets were/are already effectively annuitized, and whatever financial plan we already have is based on that. So the path of least resistance is to accept the annuity. Alternatively, we might wish to ask whether we would buy an annuity if we already had in our possession the lump-sum offered instead of the annuity. (i.e. make an explicit decision to buy or not to buy the annuity.)
The annuity decision will be built on very many factors, a large number of these, both qualitative and quantitative, are discussed. While I clearly don’t know what the future will hold, some of the basic facts upon which we have to make decisions in decumulation are the same as those in accumulation: market delivers the same returns to all participants, managing spending within/below guidelines consistent with your assets is required, make a financial plan and review at least every 2-3 years, cost is often a primary differentiator between outcomes (whatever approach one chooses), insurance costs money so it makes sense to buy insurance primarily when we are facing a low probability event with very severe consequences (in this case living much longer than the life expectancy (median age of death) for your age group, if we can consider that ‘adverse’); annuities are insurance (which happens to get cheaper as we age) so you might wish to buy them if and when you really need them and only as much as you need. But most of all, it is important to stay flexible/adaptable rather than assume that you can select a strategy or product, and then set-and-forget it for the next 30 years.
The final answer to the “Annuity vs. Lump-sum?” question will have to be customized to individual circumstances and attitudes. Typically those whose situation is not black or white, will want to explore the option with some unbiased professional help and hire a fee-only financial planner who is prepared to act in a fiduciary role to help with the decision.
While we still don’t have a view what if anything will be recovered from the bankruptcy proceedings, for Canadian pensioners to make up for the 41% funding shortfall, or when pension plan windup will actually occur, what we do know is that when windup does occur each pensioner will have to make a decision: annuity or cash-value into a LIF (Life Income Fund). In fact I did a couple of blogs directly related to this subject back in September 2011 entitled “LIF- What is it and why important for Nortel pensioners”and an earlier in March 2007 entitled “Pension or lump sum?” and a 2009 blog that also looked at some alternatives when there threat of compulsory annuitization was the only apparently available option in Doomed Nortel Pensioners? Outside-the-box Pension Options and Path to Pension Reform .
Whether decision time comes within the next year or in five or more years, we might as well start preparing for it. The choice for Nortel pensioners may be as simple as:
- the expected default annuity to be offered or
- the actuarially equivalent Lump Sum value placed in a self-managed LIF which similar to a RRIF that has a cap on annual withdrawals in addition to the usual minimum required annual withdrawals
(All pensioners may get an option to consider a G-LIF or Group LIF which the NRPC has been exploring and may become available at some point in time; also, if I recall correctly, Quebec based pensioners may get additional option to defer the annuitization decision for five years and leave the funds to be managed by Regie over that period.
I will focus here exclusively on the general “annuity vs. lump sum decision”.
Here is a list of some of the considerations that one might wish to factor into the decision making process toward answering one’s personal “Annuity or Lump-sum?” question (I will also discuss the more generic “When to annuitize?” question):
Reasons to annuitize:
-Longevity risk: life expectancy (the median age to which one is expected to live, i.e. half of those who are one’s current age will die before and half will live past the median) of a 65 year old male is about 82, of a female about 85 and a 65 year old couple (joint) about 90; in fact there is about 25% probability that at least one of a 65 year old couple
will still be alive at age 95. Some planners handle this by defining a ‘planning age’ which might be at the 75- or 90- percentile (rather than 50 percentile) life expectancy point for a single male/female/joint age of death for a couple. Annuities effectively bypass the uncertainty of age of death, by looking at a pool of annuitants of a given age so the insurance company can plan for a much less uncertain life expectancy of the group rather than the individual having to plan for highly uncertain age of death. Those annuitants who die before life expectancy effectively pay for those who die after.
-Market risk: not having to deal with the risk and consequences of a very bad sequence of returns (losses) which together with withdrawals necessary to meet spending needs can devastate a portfolio’s value to an extent that it might not be able to recover to meet one’s retirement needs. The insurance company calculates the annuity income on life expectancy and very conservative fixed income investments (e.g. government and/or investment grade corporate bond) and the annuitant no longer has to worry about market risk (but neither will he get the benefit of market returns of less conservative assets).
-Mortality credits: annuity income is made up three sources: return on investment, return of investment (i.e. your own capital) and “mortality credits”. The latter are a source of extra return not available by other means (mortality credits are explained here) because the source of “mortality credits” or “mortality yield” is the annuity premium paid by annuitants who die before you.
-Current health if much better than others of your age: somebody with a life-threatening or terminal illness might be less inclined to annuitize than somebody perfectly healthy and with a family history of living to a ripe old age
-Expertise/ability/willingness and cognitive-decline risk: with an annuity there is no need/ability to self-manage assets during retirement, which may be of concern due to the typically declining cognitive capability with age (e.g. see “Impact of aging on retirement income decision making”)
-Status quo bias: this might not be a ‘good’ reason to annuitize but in behavioural finance there is the concept that there is a greater fear of regret of a loss when it is due to specific action by investor, as opposed to inaction by the investor; due to this status quo bias many will choose to annuitize (i.e. continue with a pension-like income stream for life)
Reasons NOT to annuitize
-Inflation risk: typically the readily available annuities in Canada are Fixed Annuities also called Single Premium Immediate Annuities (SPIAs). A 65 year old couple with life expectancy of 90 will have to live with the corrosive effects of inflation over a 25-35 year period over which at a rate of 2-3% can destroy 40-65% of the buying power of the annuity (in Canada I am not aware of any CPI indexed annuities, though some are available in the US; however these indexed annuities are typically about 50% more expensive $25 rather than $16.67 per dollar of lifetime income for a 65 year old couple)
-Loss of flexibility: with annuitization effectively one gives up control of potentially a significant portion of one’s assets making them unavailable for large unexpected expenditures or emergencies (or estate)
-Current health is not as good as others of same age: somebody with a life-shortening or terminal illness or a family history of shorter than average life expectancy might be less concerned about exhausting assets due to longevity, and thus be less inclined to annuitize than somebody perfectly healthy and with a family history of living to a ripe old age
-Insurance company risk: will insurance company deliver on its promise or (like Nortel which at one point represented one third of the capitalization of the Toronto Stock exchange) might go into bankruptcy. So the credit rating of the insurance company selected to provide the annuity should be as close to AAA as possible, though that would not be be a guarantee that it would not deteriorate over the following 20-40 years. This is mitigated by the insurance/guarantee provided by Assuris which is a “not for profit organization that protects Canadian policyholders in the event that their life insurance company should fail… (it is) funded by the life insurance industry” and “If your life insurance company fails, your Payout Annuity policy will be transferred to a solvent company. On transfer, Assuris guarantees that you will retain up to $2,000 per month or 85% of the promised Monthly Income benefit, whichever is higher.”
-Risk tolerance low: if your risk tolerance is such that you may not have invested in government bonds, then buying an annuity you are foregoing the risk premium that you would likely earn if you otherwise would have invested in riskier assets (corporate bonds, emerging market bonds, stocks, etc, though you would be gaining “mortality credits”)
-Annuities bundle investment management and longevity insurance: theoretically annuities eliminate (or more likely just mitigates- see inflation risk above) longevity risk as it allows you to more simply plan, for your life expectancy rather the unknown actual date of death; unfortunately buying an annuity you are not just buying the longevity insurance you may want, you are typically also locking in long-term government/corporate bond rates even if you were not planning to invest in them, as well as ongoing (unknown) insurance company costs/fees. In the US you can buy unbundled “longevity insurance” which is not available in Canada; this type of insurance for a 65 year old typically costs almost an order of magnitude less than an immediate annuity for a similar income stream, but lifetime income only starts at age 85 if you are still alive at that age.
-Costs: annuity costs are rather obscure and it’s unlikely to be made explicit (they would include insurance company administrative/management costs and safety factors used by insurance companies on life expectancy and profit margin for a shareholder owned insurance company), LIF costs should be very transparent with major components being administration and investment management fees, and would be very low if you go to an online broker. Some analyses suggest that according to Money’s Worth Ratio, a measure that insurance companies like to use, MWR is about 0.95-1.0 where the MWR is defined as the Expected Discounted Present Value (EDPV) of annuity cash flows when discounted at the risk free rate divided by the initial premium (for an MWR definition see Annuity Markets Around the World: Money’s Worth and Risk Intermediation). But most retirees would tend to invest at least somewhat more aggressively than government bonds so the appropriate discount rate should likely be higher and thus the corresponding MWR lower. The high MWR might fool some to think that this is not a bad investment, however James Hymas in Canadian MoneySaver’s March/April 2011 issue in “Annuity decision” estimates using 2005 US Social Security longevity data that (in his example) the insurance company has to only “earn 0.8% of interest on the invested capital to meet its obligations”. He then concludes that “annuities are a poor investments but annuities are excellent insurance” (of course the Social Security longevity data does not factor in any difference between total population and annuitant population life expectancy, if any.) Annuities being possibly some of the most opaque financial products might increase one’s concerns about allocating more than absolutely necessary to such insurance. As Hymas indicated, annuities are not investments but insurance. Insurance is not free and insurance companies are now mostly for-profit public companies rather than the historical non-profit mutual insurance companies.
-Getting government bond rate return with lower insurance company credit rating: a guarantee provided by the insurance company or Assuris is not equivalent to a GIC or a Government of Canada guarantee. So even if you might be so risk averse as to only invest in government bonds, since annuities are typically priced based on long-term Government of Canada rates, buying an annuity is like signing up for government bond rates without government guarantees (if government doesn’t have the funds they can always print some more, not so for insurance companies)
-Bequests: how strong a preference/desire one has for leaving an estate can strongly influence the decision; no desire to leave a bequest would tilt one toward considering an annuity, whereas a strong desire to leave a bequest would tilt one toward not annuitizing (at all or not completely)
-current historically low interest rates: buying an annuity today is effectively locking in the curreny historically low rates for the life of annuitant (for 65 year olds possibly for as long as 30-40 years)
If annuitization is desired or necessary, consider also:
-Age >75: mortality credits start being large enough to overcome annuity costs (estimated by some experts in the 2-3% range according to a research paper by Milevsky), so ideally (from an investment point of view) you would want to annuitize after age 75…this consideration might push those over 75 to annuitization while those under 75 to lump-sum (LIF) some of which might be annuitized later
-Staged annuitization: those who must (or would like to) annuitize might wish to annuitize as needed or just-in-time as driven by requirement to annuitize according to some criteria (I’ll discuss a possible approach to the “When to annuitize?” question further on in this blog); staged annuitization would mitigate some of the risk of investing all at once at the current historically low interest rates and would in effect provide interest rate diversification over time
-Tax considerations: if pensioner is still working and earning a significant income (s)he might not wish to take an annuity as that might drive the annuity income to be taxed at much higher rate; this consideration might push those still working to lump-sum/LIF (Also, if lump-sum is selected, is there some portion of the commuted value, should it exceed some limits prescribed in Canada’s income tax laws, become taxable as it would have been in the case with the lump-sum choice at retirement? Even if this was the case, after the 41% haircut that Nortel pensioners took, it might not be an issue for the vast majority of pensioners.)
-Marriage status and survivor benefit of pension: if pensioner was married at retirement, the pension comes with survivor benefits (Nortel pension typically came with 60% survivor benefit) so the default annuity to be offered would likely come with similar terms (but no inflation protection); if pensioner was not married at retirement, no survivor benefit might be included (perhaps beyond some specified guaranteed income period, typically 5 or 10 years). The replacement annuity might be offered with new survivor options (e.g. 0%, 50%, 60%, 90%) and the LIF would come with complete freedom to use in pensioner’s or spouse’s life, subject to LIF rules; this consideration might push those married toward LIF/lump-sum for greater flexibility or some to mix of single and joint annuity from another annuity provider in the future
-Other dependents: should one have (non-spouse) dependents (e.g. disabled family members) who are being supported by the pensioner from the pension, the pension income dies with pensioner and spouse, leaving the dependent fully exposed; this consideration might push one to lump-sum/LIF
-Other lifetime-income and assets (CPP, OAS, other pensions, other annuities, RRSP/RRIF, LIRA/LIF, TFSA, non-registered assets): the more one’s basic/non-discretionary expenses are covered by other lifetime income sources (especially if indexed like OAS/CPP), the more one might lean or be driven to lump-sum rather than an annuity. This would be even more so if one’s other assets were sufficiently large to cover all other expenses (those not covered by lifetime income sources) using such low withdrawal rate that there would be little risk of running out of money
-Expenses not covered by other lifetime income sources: specifically one’s basic (non-discretionary minimum) and discretionary annual expenses, not covered by other pension income, as a percent of one’s total assets available to draw from is an important parameter; for a 65 year old individual/couple <3-4% of assets would provide flexibility to lean toward a systematic withdrawal plan (assuming risk tolerance compatible with a balanced portfolio), while >6% might suggest some annuitization
-Risk tolerance: risk tolerance is a combination of willingness and ability to take risk, i.e. temporary fluctuation of assets or permanent loss of part or all of risky portion of assets; one measure of willingness to take risk would be to look at the type of investments one has been using in the past (e.g. somebody mostly invested in GIC and bonds might be deemed to have very low willingness to accept risk) and how one reacted during the 2008-2009 market crash (e.g. similar if they dumped stocks after they crashed). If risk tolerance is so low that you would likely invest your lump sum into fixed income securities only, then you might be a candidate for an annuity. But there is no such animal as “risk-free”. Annuitization (fixed immediate annuity) would deal with market and longevity risk, but would aggravate the exposure to corrosive effects of inflation risk.
-Asset allocation- where does an annuity fit: one way to deal with an annuity is to build it in as part of one’s fixed income allocation
-Handling of PBGF guarantee for Ontario pensioners: the mechanism is unclear of how Ontario based Nortel pensioners’ PBGF guarantee would make whole the first $12,000 of pension if lump-sum is chosen (as opposed to a default annuity); i.e. will there be a lump-sum to cover the shortfall or the payment will be made as an annuity?
-Assuris guarantee: if annuity>$2,000/mo, is annuity offered split between multiple insurance companies to maximize available protection in case of insurance company default
-Partial annuitization: will there be an option to take partial annuitization and the rest in a lump-sum
-Investment Policy Statement (IPS): ideally you might want a qualified/trusted fee-only advisorwith a fiduciary level of care to prepare an IPS and make the annuity or lump-sum decision in the IPS’s context; the IPS typically looks at your personal/family goals and objectives, your assets (including income sources) and liabilities (including expenses/spending-assumptions), then assesses your risk tolerance and return requirements, as well as your personal horizon/constraints/tax-consideration/liquidity-requirements/legal-considerations and proposed target portfolio (asset allocation) including detailed implementation, risk management, rebalancing and decumulation strategy; the IPS should explain the trade-offs between an annuity and lump-sum given the stated goals and objectives. If the planner involved in the IPS proposes ongoing management of the portfolio, then standards of care (fiduciary), costs, required actions and responsibilities of planner and investor should be clearly specified
-‘Advisor’: If you need an advisor, does advisor provide a fiduciary level of care? Are there conflicts of interest for advisor providing annuity vs. lump-sum advice (i.e. is advisor a broker/asset-manager/planner who would benefit from not annuitizing or perhaps an insurance salesperson who might benefit from annuitization)
-Annuity rate offered in the default annuity: for those who don’t have to annuitize due to risk considerations or prefer not to for other reasons, it would be wise to compare annuity income stream with other asset allocation/decumulation strategies to gain additional insight into what one is potentially giving up with annuitization as compared to alternatives. (For the annuity this is dependent on interest rate environment, insurance company actuarial assumptions like assumed life expectancy, opaque insurance company expenses, etc, and for the asset allocation/decumulation strategy must include proposed asset allocation, returns and volatility assumptions, and planner/manager costs; if GLIF offered, then it should also be included in the analysis including the guarantees and costs/fees associated with it.)
-Capability/willingness to potentially manage a large portfolio, dynamically manage withdrawal rates and annual spending: if you are unwilling/unable to manage your portfolio of assets that might push you further toward annuitization and/or to working with a financial planner for a fee, as that would basically free you from any investment management activity other than trying to manage your spending within your available income sources. For those who might chose a 3rd party to (plan and) manage assets you must factor into the return assumption the planner/manager cost to come up with realistic comparison.
Annuitize or not? If yes, when and how much?
There are a number of approaches that one can take, and just because they come at the problem from a different direction does not mean it is necessarily wrong, it may just be different and/or driven by specific individual circumstances . For example:
-some will argue that you want to cover your Basic (but not Discretionary) income requirements with (preferably inflation indexed) annuities/pensions (like OAS, CPP, other pensions) to make sure that these are covered for you (and/or your spouse/partner) are alive. Once basic expenses are covered they may suggest the balance of the funds be allocated to fixed income and equities with equities ranging from 20-60% of the remaining assets or just build annuities into your fixed allocation.
-Wade Pfau in a very interesting just released paper “Efficient frontier for retirement income”suggests that the optimal decumulation approach for a 65 year old couple with a spending goal (in excess of Social Security income) equal to 4% of assets at retirement date adjusted annually for inflation (when considering some mix of stocks, bonds, fixed SPIAs, and indexed SPIAs and VA/GMWBs) is a mix of stocks and un-indexed fixed SPIAs. There is an earlier paper by Ameriiks, Chen and Ren “Comparing spending approaches in retirement” in which they compare different decumulation approaches (including annuities) but you must bear in mind the fees here are those that “could be available in the marketplace” for fair comparison of the capabilities of different approaches, but do not necessarily represent what can/is typically be bought in the marketplace (especially in Canada); so results may not be representative of realistically available outcomes. In a 20011 blog entitled Vanguard GLWB vs. other decumulation strategies I compare fixed annuities with Vanguard VA/GMWBs, high cost VA/GMWBs and proportional withdrawa strategies with and without Floor and ceiling constraints.
-others suggest that you annuitize part or all your retirement assets at age 75 or later and/or do so perhaps in three stages between age 70-85
- respected pension expert Zvi Bodie for years has been arguing that the only safe solution is to use inflation indexed annuities for all of one’s retirement needs. Even if one might not actually implement it as such, a good measure of the cost of retirement is the premium for an indexed immediate annuity to cover the estimated annual expenses; for a 65 year old couple (in the US where it is available) the annuity rate would be about 4% or a premium of 25x the required indexed annual income (if you can afford this- few can).
-An un-indexed annuity for the 65 year old couple would be about 33% lower, i.e. an annuity rate of about 6% or about 17x the annual un-indexed annuity income. So a retiree 65 year old couple could choose between the perceived relative certainty of an inflation indexed annual income stream of 4% of the premium or take a higher annual un-indexed income of 6% at the same premium (start with a 50% higher income but live with the inflation exposure over the next 30+ years; in both cases one makes an irreversible decision to give up control of a large pool of assets (25x/17x annual income) in exchange for this ‘relative certainty’ guaranteed by the insurance company. Alternately one could start with 4% withdrawal strategy from a balanced portfolio and accept some risk of running out of money after about 30 years, but with some reasonably high probability of having a significant residual estate.
-withdrawal rate strategies vary, for example the traditional 4% (safe withdrawal rate or SWR) rule whereby you draw 4% of initial assets and then adjust that initial dollar value each year for inflation; if past returns are a reasonable representation of the future, then this approach based on historical data appears to be able to deliver 30 years of income from a balanced portfolio with low probability of running out of money. More recently many have suggested that due to much lower current forecasts of future returns, so called safe withdrawal rates today are lower than 4% (Wade Pfau suggested that it may be as low as 2%). Since the future is unpredictable, I like to think that considering an approach with built-in flexibility (e.g. like the next withdrawal strategy) has better chance of not running out of assets.)
-others argue that a proportional 4% rule meaning that each year you draw 4% of your assets available at the beginning of each year- still others fine tune this approach by adding a floor and a ceiling to annual withdrawals to reduce income volatility relative to the portfolio volatility; this proportional withdrawal strategy would never run out of money but of course could be quite volatile and require that retiree be able to handle that volatility (this proportional 4% withdrawal strategy is more conservative than the traditional 4% one; of course a 75 or 80 year old couple can draw more with this strategy than 65 year olds)
-in a number of papers (e.g. “Lifelong retirement income: The zone strategy”) Jim Otar proposes a zone-strategy where he defines asset points below which you must annuitize (e.g. cost of inflation indexed annuity) and above which you can proceed with the safe withdrawal rate (essentially the traditional 4% rule). (Unfortunately, there is little gap, grey zone in his nomenclature, in today’s interest rate environment between his red and green zones.
Now let go back to what we are trying to here, i.e. making the annuitization decision.What follows is not intended to override any of the arguments/considerations discussed above in Reasons to annuitize, Reasons NOT to annuitize, and If annuitization is desired or necessary, consider sections above. In the discussion to follow we’ll just add a quantitative dimension to the decision making process.
One approach that may provide maximum flexibility is to start by using the proportional 4% rule, but only start considering fixed SPIAs (fixed immediate annuities) when required withdrawal rates to meet Total expenses rise (well) above 4% (say 5%) but must start buying an annuity no later than when assets approach (say within 20% of) the level necessary to cover Basic (or minimum) expenses with the annuity rate (in both case expenses heare refer to those not covered by existing lifetime income sources. Furthermore, only annuitize as much as necessary to allow continuing with the proportional 4% rule for the remaining assets. I haven’t simulated this as yet, but on the surface it might be workable, and might provide maximum flexibility.
In the meantime I built a couple of spreadsheets that might help us explore the trade-off between annuitizing or not; both the Generic annuitization decision and (Nortel) more specific Lump-sum vs. annuitization decision.
We’ll use the set of common assumptions:
-65 year old couple
-risk tolerance is such that a balanced portfolio is appropriate
-they are are comfortable with the proportional 4% rule
-they are healthy with at least average life expectancy, would prefer to leave a bequest and are comfortable managing their own portfolio of assets
Furthermore a couple of breakpoints are defined which might spur us to action:
-the point at which decision to start considering annuitization is when assets drop significantly (say >10-20%) below those required to meet Total expenses (less other sources of lifetime income) with proportional 4% withdrawal rule
-the point when you must annuitize is where Assets approach (say within 20%) those required to meet Basic Expenses (less other sources of lifetime income) using an Annuity Rate of 6% (specified as input)
Furthermore, other considerations aside, we’ll consider annuitization decision as an insurance (rather than an investment) decision. Since the cost of insurance is not free, and the cost of annuity actually drops with age (i.e. annuity rate increases with age), and since interest rates are now at historical lows we might consider the risk of further interest rate reductions (i.e. interest rate driven annuity rate increases) low, we’ll only buy the insurance as we near the breakpoint(s) and we only buy as much as we might need (above some minimum level governed by cost considerations); i.e. we’ll try to do it just-in-time and just-enough to see if markets improve and we don’t have to annuitize additional assets
As you use these spreadsheets to explore various options, remember Richard Hamming’s advice that “computing is for insight, not numbers”. So here we go:
Let’s examine the spreadsheet which considers on Sheet 3 the Generic annuitization decision and on Sheet 2 the (Nortel) Lump-sum vs. annuity decision.
Start with Sheet 3 the Generic annuitization decision where required inputs are shown in red
In this example, the couple has $700K assets and $25K of pensions; Basic (minimum) and Total expenses (net of tax) of $40K and $50K respectively. Annuity rate is 6% and proportional withdrawal rate (PWR) is 4%. This constitutes the Base Case which is displayed in the top right-hand panel. The required withdrawal amount is $37,500 to cover Total expenses (pre-tax) which corresponds to 5.36% of the available $700,000; to get to the 4% withdrawal level, above which we start considering annuitization of some assets, we’d need $937,500 of assets. So our $700K assets are in-between the $937,500 (driven by Total Expenses(less existing pensions, to be generated at 4%) where we might start considering annuitization but above $416,667 (driven by Basic Expenses (less existing pensions) to be generated at 6% annuitization rate). A withdrawal rate of 5% for a couple of years would not be considered worrisome by many, though beyond 6% would require some action; still others would be driven to at least take some or all of the lump-sum as an annuity for additional peace of mind, especially if the annuity rate is very attractive.
Let’s examine the impact of annuitizing $300K of the $700K assets (as is specified in the left panel as an input). The result of this is shown in the bottom half of the right hand panel. Note that Total pension/annuity income increased from $25K to $43K, assets decreased from $700K to $400K and we reduced withdrawal ratio from 5.36% to 4.88%. While with $400K assets we are still below the now $487,500 level where annuitization might start to be considered, we are now well above the new $116,667 level, about 20% above which we’d have to annuitize to protect coverage of Basic expenses. You can explore other situations including your personal circumstances using Sheet 3 of this spreadsheet.
Now let’s look at Sheet 2 of the spreadsheet which considers the (Nortel) Lump-sum vs. annuity decision:
Here on Sheet 2 the left panel requires (and here uses) the same input data, except now Annuity offered and Lump-sum offered are both required inputs whereas Annuity rate (now in ‘black’) is calculated rather than provided as an input.
On the right-hand side of the above figure we can now compare the outcomes, with top panel showing situation if Lump-sum is selected and lower panel the case if the Annuity is selected. Note that most may be perfectly comfortable with 3.88% (<4%) withdrawal rate and $966,667 of assets, slightly above the $937,500 level at which we might start considering annuitization (based on Total expenses above the $25K pension and the proportional 4% withdrawal rate). Also note that $0 is required to be annuitizied additionally to get to the 4% PWR (proportional withdrawal rate), the assets are above the $937,500 where annuitization might start to be considered and 2.5 times higher than the $416,667, approaching which annuitization would be required.)
The bottom panel on the right-hand side, illustrated the situation if the Annuity is selected instead. Here, after including the new annuity, the required withdrawal rate is shown at 3.07% (<<4.0%) and existing assets of $700K are above $537,500 where annuitization might start to be considered and well above (almost five times higher) the now $150K floor approaching which annuitization would be required based on Basic (minimum) expenses. Again one case use Sheet 2 spreadsheet to explore different Lump-sum vs. Annuity scenarios.
It is worth noting that depending on one’s aversion of annuitization, reducing or eliminating, temporarily or permanently, discretionary spending would be another mechanism of reducing the required withdrawal ratio to a more comfortable level.
On could look at the annuity or lump sum decision very simply and accept the annuity option (“status quo bias”) as these pension assets were/are already effectively annuitized, and whatever financial plan we already have is based on that. So the path of least resistance is to accept the annuity. Alternatively, we might wish to ask whether we would buy an annuity if we already had in our possession the lump-sum offered instead of the annuity. i.e. make an explicit decision to buy the annuity.
Considering this a fresh opportunity to explicitly weigh the pros and cons of annuitization vs. lump-sum, we need to look at a series of trade-offs and considerations some of which are:
-longevity vs. inflation risk
-government bond returns boosted by “mortality credits” vs. risk premium that may be earned with alternative asset allocation strategies
-bequest preference (requirement, desire, don’t care)
-ability/willingness to manage assets and spending
-desire for control and flexibility
-insurance company risk
-extent to which other lifetime income sources already cover basic and/or discretionary spending needs and objectives
-annual withdrawal requirements from assets to meet basic and/or discretionary spending
-extent to which real annuity income compares to alternative asset allocation and decumulation strategy
-available/offered options upon windup (partial/staged annuitization, survivor benefits,
-and other considerations (age, still working, married vs. single, fiduciary advisor, handling of PBGF guarantee if annuitization not chosen, dependents other than spouse…)
-as well as the quantitative consideration which can be explored via the spreadsheets
Therefore this is potentially a non-trivial exercise due to the multitude of considerations that can come into play. The answer to the question will have to be customized to individual circumstances and attitudes. Most of those who want to explore this option will likely need some unbiased professional help for this task.
While I clearly don’t know what the future will hold, some of the basic facts upon which we have to make decisions in decumulation are the same as those in accumulation: market delivers the same returns to all participants, cost is a primary differentiator between outcomes, managing your spending within/below guidelines consistent with your assets, make a financial plan and review at least every 2-3 years, insurance costs money so it makes sense to buy insurance primarily when you can’t self-insure (low probability catastrophic outcomes) and annuities are insurance (which happens to get cheaper as we age) so you might wish to buy them when you really need them and only as much as you need, but most of all stay flexible/adaptable rather than assume that you select a strategy or product and set-and-forget looking at it for the next 30 years.