Lifetime Income Payments Or Lump Sum: How To Decide?
Many investors at some point in their lives face the decision of whether to take a lump sum payment or take a stream of income payments.
This decision can involve a company pension plan at retirement, a private annuity that an investor is thinking about purchasing or even a judicial/lottery settlement.
Regardless of the situation, it is important to critically analyze the pros and cons of all available options.
Frequently, lifetime versus lump sum payment decisions cannot be reversed once agreed upon and solidified.
Therefore, it is imperative to take all factors into account and make well-informed, wise decisions. Whether this is done independently or with the guidance of a financial advisor, doing a thorough analysis of all choices can be one the most important decisions in your financial life.
Below are just a sampling of the issues that can arise when considering payment schedule options.
Implied Return On Investment
This is often the most important factor. By doing a discounted cash flow analysis, the implied rate of return is estimable by taking the income stream payments vs. the lump sum.
Given average life expectancy, an investor would measure the "cost" of giving up the lump sum in year 1 and then add the positive cash flows for all the years thereafter until life expectancy is met. This calculation can be done with a calculator or through an excel spreadsheet.
Often, regardless of the situation, the return is low (in the 2.5 percent - 4 percent range). The rates usually mimic longer term bond rates fairly closely.
These low rates are why it is frequently appealing and justified to take the lump sum, all else equal.
Over time a well-diversified portfolio including ETFS like iShares S&P 500 Index (ETF) (NYSE: IVV), iShares IBoxx $ Invest Grade Corp Bd Fd (NYSE: LQD), iShares Barclays 7-10 Year Trasry Bnd Fd (NYSE: IEF) or a high quality stock like Johnson & Johnson (NYSE: JNJ) can easily beat a return in the 2.5 percent - 4 percent/yr. range (albeit with some volatility and no guarantees).
Occasionally, there are pensions that produce implied guaranteed returns in the 6 percent - 7 percent range. In these cases, a diversified portfolio cannot compete on a risk adjusted basis; in those rare cases, taking the income stream makes sense.
Again all these implied returns assume living to life expectancy; if you live longer, the actual return earned would be more, and if you live for a shorter time, the return would be lower.
A special note on private annuity returns: Many firms have been advertising a "6 percent guaranteed return" or "ability to capture stock market upside with no downside risk." As the saying goes, "If it sounds too good to be true, it usually is." No exception here. The vast majority of the time when we do an analysis of these products, the "true" rates of returns are similar to long-term U.S. government bonds (2.5 percent - 3.5 percent).
Assuming the decision involves a pension plan and is a fully qualified account, the tax factor is not a major issue. The income payments are fully taxable at the federal level as would be the lump sum money once funds are removed from the IRA. If the pension plan is taken as a lump sum and is qualified, virtually without exception, you should roll the pension directly into an IRA.
When looking at purchasing a private annuity, there are positive and negative tax aspects vs. leaving the money invested in traditional assets. If funds are invested in an annuity, for as long as the funds remain there and are in the "accumulation stage," all taxes are deferred. However once payments begin, a portion of the funds are non-taxable (return of principal) and the other portion is taxed at ordinary income tax rates. This eliminates favorable long-term capital gain or qualified dividend rates of 0 percent - 20 percent available on a traditional portfolio.
When dealing with a judicial settlement, sometimes there is a special provision in which the payments will be fully tax free. In the same vein, if taking the lump sum, that entire amount is also completely tax free. In this instance it is important to compare pre-tax and post-tax returns when comparing the return of the income stream and a traditional portfolio.
Flexibility/Availability Of Funds
This can be a major decision point. For investors with a relatively large liquid asset base/portfolio and little steady income outside of social security, having ready access to these funds might not be a large concern. In fact, for income diversification purposes, it might make sense for these types of investors to receive more steady reliable income vs. adding to their already large/liquid portfolios.
However, for the majority of people having ready access to the money (a lump sum that can be accessed at any time) has value. Once the decision is made to take the payments, it is irreversible and the investor does not have access to the funds (save for the periodic payments) again.
Taking the lifetime income payments on a pension plan is essentially buying insurance against living a long time (well beyond life expectancy). The longer the life, the more money you make over your lifespan and the higher return you get on your decision.
If your family has a history of longevity and if you are in very good health – all else equal – taking the annuity payments might be the way to go. Of course, on the other hand, if you have significant health issues, the lump sum may be a better choice!
Benefit Structure (Joint, Single, etc.)
Depending on you and your spouse's exact financial situation, it might make sense to take the "single" option and get the higher lifetime payments on yourself. Alternatively, the joint option (which results in lower payments, but a continuation of the income stream for your spouse if something happened to you) could be the better choice.
This depends on many factors that include the amount of liquid assets, life insurance, what other income is coming in and spending needs. Single investors usually would take the single payout option.
Eric Mancini is the director of investment research at Traphagen Financial Group, an independent investment advisory firm located in northern New Jersey.
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