Upon approaching retirement, you may be asking yourself, “Should I take the lump sum or the annuity payment option with my pension plan?” We get this question often, and the difference in lifetime value between options can be significant. Before making any decisions, you’ll need to complete a careful and thorough analysis. A competent financial planner can help you assess which option best suits your needs and review how these options may impact other aspects of retirement.
Even if you’re not near retirement, taking steps to better understand your options now can significantly impact your retirement later. Let us first go over the two payout options for your Occidental Petroleum Corporation (Oxy) Retirement Plan, as neither is without risk:
With the annuity option, the pension plan sends regularly scheduled payments over your lifetime. With a joint annuity, the guarantee extends to the life of a designated beneficiary, such as your spouse. An actuary calculates these payments, which are contractual regularly scheduled disbursements from an insurance company. When you take this option, you relinquish control over your funds with the lump-sum option. This option may be a good choice if you’re looking for a steady income stream. However, this option may incur certain risks associated with privately funded and uninsured pensions.
The lump-sum option gives you the benefit of a fully-vested cash balance in one large payment. By rolling these funds into an Individual Retirement Account (IRA), you control the investments and distribution timing. This option affords more options and increased liquidity over the annuity option. Moreover, you have more control over taxes through the timing of distributions. While this option may give you more control over your money, there are risks associated with investing.
Familiarity of a Paycheck
A significant aspect of deciding between the options above comes down to your overall financial expectations while factoring in your future income needs, aversion to risk, and time horizon. Let’s begin with the annuity. While getting a consistent payment for the rest of a lifetime sounds good, is it the best option?
The annuity option can provide a sense of security through steady income streams and harks back to the familiar feeling of receiving a paycheck while working. However, this sentiment ignores many inherent risks often overlooked with annuity payments.
For instance, the payments in the Oxy Plan do not have Cost-Of-Living-Adjustments (COLAs), which means the promised payments may not keep pace with inflation throughout retirement.1
The sense of security also extends to supporting your spouse in the event of your passing. For example, a spousal benefit allows your beneficiary to receive payments after you die. This form of insurance often comes at a cost. However, the greater the benefit for the beneficiary, the lower your current monthly payments will be. Furthermore, these benefits would probably not keep pace with inflation throughout the surviving spouse’s lifetime, given the lack of COLAs with the plan.
There are no guarantees with private pension plans either. The PBGC (Pension Benefit Guaranty Corporation) is a federal agency that insures private pension plans guaranteeing benefits in the case of insufficient funds. PBGC does not cover the Oxy Retirement Plan benefits. As an Oxy retiree, your future annuity payments may suddenly stop if the company or pension becomes insolvent.1
Potential Benefits of Taking the Lump Sum
The alternative option to the annuity and its associated risks is the lump-sum option. While the lump-sum option is not without risks, the option does offer greater flexibility throughout retirement and provides the potential for a higher lifetime total benefit.
In terms of flexibility, the lump-sum option gives you more control over your tax picture. You can delay distributions until age 72, maximizing the amount of time your lump sum can potentially grow tax deferred. Additionally, you can access more of your money immediately for pricier purchases, such as a new car or big-ticket home repair. In contrast, you are limited to your monthly payment with the annuity option. Finally, by investing the lump sum, your benefits have a chance to keep pace with inflation, as you can purchase income-producing and growth-oriented investments.
Lump Sum vs. Annuity Options
To further illustrate these points, the chart below illustrates the impact of taking the lump sum vs. the annuity payments over 30 years from age 65 to 95. For this example, we assume a lump-sum value of $750,000 rolled into an IRA compared to an annualized annuity payment of $42,354 (represented by the blue and orange lines, respectively). Additionally, we assume a 5% rate of return on the IRA assets and delay the distributions until 72, when required minimum distributions (RMDs) begin. Finally, we assume spending needs are $75,000 annually, growing at 3.5% due to inflation, represented by the dotted black line. The chart assumes distributing only RMDs each year, which are required regardless of whether you need funds or not.
We assume an interest rate of 2.5% and a life expectancy of 19.07 based on the average of a 65-year-old male and female actuarial assumptions to calculate the future annuity stream for the illustrations in this article.2 Higher interest rates and shorter life expectancy values increase the value of payments. Lower interest rates and longer life expectancy values lower annual annuity payment amounts.
As you can see, the annuity payments remain flat while spending needs increase due to inflation. While these payments make up a sizable portion of spending needs today, they do not account for even a quarter of expenses at age 95. However, the required minimum distributions from the IRA do a much better job of keeping pace with inflation so long as the IRA grows at its projected rate of 5% and the RMDs are made as expected, based on the IRS’ distribution formula.3
Cumulative Benefits of Each Option
Another way of looking at this is to see the cumulative lifetime value of benefits from either strategy, exhibited by the chart below. This chart compares each option’s potential cumulative lifetime benefits using the same assumptions made above. The blue area represents the anticipated lifetime cash flows and growth of rolling over a lump sum to an IRA. The orange area represents the lifetime value of expected annuity payments. In this example, the annuity yields just over $1.2 million, while the lump sum would provide almost $2.6 million in potential benefits.
Delaying IRA Distributions Until 72
In the next chart, we further break down the lifetime cumulative value of these two options. We can see how the cumulative value of IRA distributions exceeds the cumulative annuity payments at age 93, even with delaying distributions for seven years at age 72, compared to beginning annuity payments at age 65. In this chart, you can also see how the distributions and rate of return impact your lump-sum value over time (in blue). This chart suggests that the IRA balance would be at approximately $783,000 at age 95. (The yellow line represents cumulative RMDs from the IRA and the orange line cumulative annuity payments.)
The chart assumes delaying withdrawals from the lump-sum IRA account until age 72, taking only RMDs after that.
Taking IRA Distributions at Age 65
In the examples above, we assume that the Oxy employee can wait until age 72 to begin taking distributions in retirement. What would happen if the Oxy employee started taking distributions from the IRA at age 65 (the same time annuity payments begin)? The model below outlines this scenario. From age 65 to 72, we assume the participant withdraws 3.5% each year to cover expenses in retirement. At age 72, we presume the IRA holder takes only RMDs annually from the IRA.
The Chart assumes a withdrawal rate of 3.5% of IRA account value starting at age 65. At age 72, distributions changed to calculated Required Minimum Distributions per IRS tables.
By starting distributions from the IRA earlier, the overall cumulative benefit of the lump sum is reduced. However, the total cash flows and growth from the lump sum still exceed that of the annuity option.
While the preceding graphs highlight the potential benefits of the lump-sum option over the annuity option, these benefits don’t come without risk. Assessing these risks can be done with careful retirement planning. It should include other aspects of your financial picture, such as Social Security benefits, 401(k) Savings, deferred compensation arrangements, and more. We can incorporate all these aspects when building your retirement plan to help you retire with peace of mind. Call us at 713-850-8900 to get your financial plan. We will review your goals, anticipated spending needs, and financial holdings during our planning meeting. Our analysis will consider your time horizon, risk tolerance, overall financial situation, and unique needs as an energy executive when reviewing your pension options.
Each option has the potential to provide for your spouse in the event of your passing. The annuity option provides continuity of payments to your spouse after you die. However, they stop once your spouse dies. With the lump-sum option, the surviving spouse or beneficiary inherits the IRA. Additionally, if your spouse dies, your children or other beneficiaries inherit the IRA.1
Market volatility can impact the availability of funds inside an IRA. For this reason, investing the lump sum in a prudent manner consistent with your tolerance and capacity for risk. A qualified investment advisor specializing in managing retirement capital, such as The Goff Financial Group, can help you manage risks associated with investing. Past performance is no guarantee of future performance and investing always involves risk.
This material was prepared using third-party resources and does not necessarily represent the current views of The Goff Financial Group, which are subject to change without notice. The information used to prepare this information comes from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.