By Kevin P. Brosious, CPA, PFS, CFP

To take a lump sum distribution from a pension fund or to start a fixed monthly payment (annuity) can be a difficult decision. Clients’ circumstances can change, and that alters how the analysis is completed. For example, is the client counting on the funds to immediately finance retirement expenses, or can the funds be invested for distributions in some future period or even earmarked for heirs?

Consider a 66-year-old client that has the option of taking a lump sum of $400,000 from his employer’s defined benefit plan or an annual annuity of $28,000 for the rest of his life. According to the Social Security Life Expectancy Calculator, the life expectancy for a 66-year-old male is about 18 years.

The first thing I consider is the internal rate of return (IRR). The internal rate of return is a measure of the investment’s rate of return. In this case, the client’s investment is the $400,000 lump sum. For this investment, he will receive $28,000 annually. Using a spreadsheet or financial calculator, you can calculate the IRR as 2.6%. So, basically, the company would be giving him a 2.6% return on his money if he foregoes the lump sum and takes the annuity. Certainly, a better return than the client would receive with current money market or CD rates and better than most bond yields.

Next, consider net present value (NPV). Since the IRR represents the point where the NPV equals zero, then any investment that returns 2.6% would be a breakeven with the annuity, and it wouldn’t matter if he took the lump sum or the annuity. However, if you believe the lump sum could be invested to earn more than 2.6%, then the discount rate would be higher and you would get a negative NPV, which means it would be better to take the lump sum. For example, assume a return of 5%. The NPV would be a negative $73,000, which means the client would be better off taking the lump sum by about $73,000.

The analysis should also include when these funds would be needed. If the client would be drawing down funds immediately, you would want to minimize investment risk and may lean toward the annuity. However, if the funds are part of a larger portfolio producing enough income to satisfy retirement needs, then the lump sum could be invested in higher-producing (greater risk) assets that would exceed the 2.6% IRR.

Consideration should also be given to the fact that some annuitized income usually improves financial plan results, and if the annuity is taken the client could be more aggressive with other investment funds since the annuity cash flow would be undisturbed by the gyrations of the stock market.

You can easily compare the client’s annuity offer via the company pension plan to a commercially purchased immediate annuity by referring to immediateannuities.com and requesting a quote for a $400,000 life annuity for a 66-year-old male. They quote a monthly life annuity of $2,031, or about $24,400 annually. Obviously, the annuity from the company pension is a superior choice.

Pension funding risk is always a consideration. So, if you recommend the annuity, also consider if the company’s pension plan will stay solvent during the client’s retirement period. The strength of the company’s plan can be determined by referring to the annual funding notice that is required to be sent to all persons covered by the plan. The funding notice will show the plans funding target attainment.¹ S&P assigns a strong rating to plans funded above 90%, above average for plans between 80% and 90%, below average for levels 60% and 80%, and weak below 60%. This can also be found on the company’s IRS Form 5500. However, should a company’s plan run into financial difficulty, it would be insured by the Pension Benefit Guaranty Corporation (PBGC). The PBGC guarantees plan annuity payments to a certain level of funding. Assuming this was a single company pension plan, it would be insured to about a $6,400 monthly payment for a 66-year-old male.

Other considerations would be if the client wanted a survivor annuity for a spouse or certain annuity payments. All these scenarios can easily be analyzed using a spreadsheet or financial calculator.

Of course, the analysis deals with average life expectancy. Some clients may have a family history of longer or shorter life expectancies. Longer life expectancy would always improve the return of the annuity; shorter life expectancies would lower the annuity return.

¹ The annual funding is calculated without adjusted interest rates (two-year average) and adjusted interest rates (25-year average).

Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc., located in Allentown and Plymouth Meeting. He can be reached at kevin@wealthmanagement1.com.

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