A Bet Your Life Decision for Retirees – Lump Sum or Annuity


Many retirees are facing a potentially life-changing financial decision. Ford Motor Co. recently offered 90,000 of its retirees a single lump sum payment that would take the place of their company-sponsored retirement annuity, which pays the retiree a guaranteed amount of income for life. General Motors plans to make the same kind of offer to 42,000 of its retirees. Others companies with billions of dollars in pension assets are expected to follow suit. Thus, hundreds of thousands of retirees are likely to face this choice over the next few years.

These are “bet your life” offers in the sense that the decision could improve the retiree’s financial situation or result in significant losses with no realistic possibility of recovery. Offers like those made by Ford call for careful study and analysis by qualified and unconflicted advisers. Unfortunately, in the past, retirees have often fallen victim to bad advice from unscrupulous or incompetent advisers.

For Ford and GM, it boils down to this: Given the uncertainties regarding the adequacy of contributions, investment performance, and longevity (the number of years the plan must pay out), there is a risk that the plan’s assets will be insufficient to cover the payout obligations. Ford and GM want to transfer the risk to the retiree, and they are willing to pay a price ? the lump sum ? that they have determined to be the discounted value of their future payment obligations.

But is it a good deal for the retirees? In computing lump sum offers, companies with defined benefit plans like Ford and GM are required by law to use a discount rate derived from long-term corporate bond yields. That yield is now about 4.20 percent. Until this year, however, those companies were required to use the yield of comparable Treasury securities, now about 2.8 percent. The difference would save Ford and GM (and cost retirees) a good deal of money, as the lower the discount rate, the lower the lump sum payments to retirees.

A lump sum payment could still make sense under certain circumstances. One’s age and health, for example, are key factors. Both the retiree and the company are playing the longevity game. The company is focused on statistical life expectancy of a large group. The retiree is focused on one or perhaps two life expectancies ? the retiree’s and the spouse’s, who may receive some payments after the death of the retiree. If a retiree accepts the lump sum and dies the next day, he or she “wins” the game. If that same retiree lives a long life, the winner is less clear. There may even be a perfect pinpoint balance where both parties win.

Another key consideration is investment risk. It is a common rule of thumb that if one withdraws 4 percent or less of savings per year, the odds of outliving one’s assets is very low (but some say that withdrawal rate is too high). Very low is good, but that is a long way from guaranteed for life.

There is another consideration for retirees under the age of 59 ?. The lump sum is usually rolled over into an IRA. The IRS imposes an additional 10 percent tax on distributions taken from a retirement plan or IRA before age 59 ?. There is an exception to the 10 percent tax if distributions are made as part of a series of substantially equal periodic payments over the participant’s life expectancy. Investors run into problems with the exception when investment losses lead them to modify or stop the distributions. If that happens, other than for reason of death or disability, within 5 years of the first payment, or, if later, age 59 ?, the exception to the 10 percent tax does not apply.

In making this potentially life-changing decision, there are a number factors ? both pro and con ? that need to be considered. Financial advisers who would advise a retiree and/or manage the retiree’s money, however, have interests that inherently conflict with the retiree’s interests. The adviser has a financial interest is gathering assets on which to earn a fee, and that interest is best served by explaining the pros but not the cons of taking the lump sum and investing it with the adviser. That interest conflicts with the retiree’s interest in understanding and considering the reasons why he or she may be better off keeping the annuity.

Financial advisers are certainly not the only advisers who must deal with inherent conflicts of interest. Like every other group of people, they cover the spectrum from honest and wise to unscrupulous and foolish, and all shades in between. It is important to know with whom you are dealing.

Retirees should be especially wary of unsolicited advice, advisers recommended by the company, and advisers giving investment advice at free lunch or dinner seminars. Keep in mind that a financial adviser with an interest in earning a fee from providing financial advice or management may promise the moon. Be skeptical. If possible, have disinterested professional (e.g. maybe an accountant, attorney, independent financial adviser, etc) evaluate the lump sum offer, as well as any proposed investments and projected rate of return.

A good starting point to find a trustworthy financial adviser is to ask other competent, unconflicted professionals for several recommendations.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.