Your client plans to retire soon and his employer's defined benefit plan offers a choice: take a monthly pension or a lump sum distribution that can be rolled over to an Individual Retirement Account. The client wants your input because a good chunk of his net worth is tied up in the plan, not to mention his retirement security.
If his main retirement goal is to be happy, have him take the pension or a similar lifetime annuity. A 2012 report from consultants Towers Watson, "Annuities and Retirement Happiness," found that among retirees of similar wealth and health, those with annuitized incomes were happier than those without annuities.
Any financial advisor worth her credentials would argue that this happiness is likely to be short-lived, though. Rising life expectancies guarantee that even low inflation will eventually erode a pension's purchasing power. Fixed incomes are like aging knees: what works at age 65 won't get you nearly as far at 80.
There's another angle. Pensions don't generate commissions or asset management fees; rollovers do. So how do you help clients make informed decisions and manage the inherent conflict of interest?
Seeing The Numbers
David Kudla, chief executive officer of Mainstay Capital Management LLC in Grand Blanc, Michigan, has worked on numerous pension-or-payout decisions. Many of his clients work for the auto companies, which have offered lump-sum buyouts to tens of thousands of employees in recent years.
For Kudla, the first round of the analysis is a math question. He knows the client's age and life expectancy (and his spouse's, if the client is married) from the IRS tables. The plan provides the pension payments and the available lump sum. Using those numbers, he can back out the discount rate — the internal rate of return — the plan sponsor is using in its calculations.
He then estimates the return the rolled-over lump sum could earn if he were managing it, based on typical historic returns of the various asset classes he would recommend. If the investment portfolio produces a higher value, then it makes financial sense to roll over the funds; otherwise, the pension can be a better choice. Armed with that result, Kudla and the client start to consider the qualitative factors in the decision.
Larry Frank Sr., owner of Better Financial Education in Roseville, California, runs customized spreadsheet calculations to compare annuitized incomes with managed accounts. In an article he co-authored for the April 2014 Journal of Financial Planning, he compared buying a single-premium immediate annuity — a privately purchased pension — to investing in simulated investment portfolios with varying allocations between stocks and bonds.
"We found that for those with normal health and normal longevity expectations, it doesn't make sense to annuitize in most cases," says Frank.