Do you wanna know the most common question that an actuary gets asked?
“How did you get that sparkling personality”
Nope, that’s actually not the most common question.
The most common question is…
“Should I choose to take a lump sum over a pension?”.
And this is exactly the kind of question actuaries love coz there’s all sorts of math involved. But put your calculators away because I want to look at all the important aspects of this issue, and math doesn’t feature a whole lot.
Three Main Situations
There are three main situations where you might have to consider between a lump sum and an ongoing pension.
- Firstly – you might be lucky enough to have a company pension and are retiring and your pension plan gives you the choice of having an income for life or a straight-up lump sum.
- The second situation is that you might be some distance from retirement but a previous employer comes to you with an offer of accepting a lump sum in lieu of a pension.
- The final option is that you might have a lump sum saved up and are wondering whether you want to buy yourself an annuity.
By the way a pension and an annuity are pretty much the same and I’m gonna use the terms interchangeably. It’s just a guaranteed income for life.
How Do You Choose?
Suppose you are faced with the choice of a steady income of $20,000 per year for the rest of your life, or a juicy one-time lump sum of $600,000.
Which would you choose?
And how do you choose?
What questions should you ask yourself?
Should you do any math?
Should you make friends with your local actuary? Yep, you should certainly do that – go on and hug an actuary!
Well I have the answer for you in the form of the proprietary Actuary on FIRE Lump Sum or Pension Quiz(TM). Simply answer a few simple questions and your quiz score will show you the right path to take.
You are going to start off with ten points.
Answer each question and either add or deduct points to arrive at a final score. That final score will tell you whether to take a lump sum or pension.
Please don’t proceed before reading these important notes.
Before we get into this let’s be clear what we are talking about here. A pension or annuity is a guaranteed income until you die. You can also usually get versions that pay out until the death of your spouse if you die first. That’s pretty sweet when you think about it. You don’t need to worry about outliving your nest egg and all that investment stuff, you just sit there waiting for your monthly check from your pension plan or insurance company.
But with all things in life there is a trade-off. Let’s explore that in the Quiz.
Given we are talking about something perpetuating for your lifetime the first questions are going to concern your general health.
Section 1 - Your Health
Q(1a) – are you in good health? If yes then award yourself a point. That means you would have 11 points. Remember you started with 10 points.
If you are in poor health and you think your lifespan might be significantly shorter than average for your age then take off a point. Don’t worry if you eventually get negative points, that’s how things work with an actuary quiz.
Q(1b) – Do you exercise regularly? If yes, then give yourself another point.
Q(1c) – are you a smoker? I’m not here to judge, but if you are then take off one point.
Now let’s examine your attitude to investments.
Section 2 - Attitude to Investments
Q(2a) – are you comfortable managing your money and investing for the long term? If you are then deduct a point. If you are fairly comfortable investing reasonably small sums, but are concerned with relying on your investments for long term security then add a point.
For question 2b I want you to consider your attitude to risk. Many people will whine about annuities and say they can earn investment returns in the market and make more money over the lifetime than might be provided by the pension. That might be true, but remember a pension is pretty much a risk-free investment. If you invested your lump sum in stocks then that has investment risk, and so it’s not really a fair comparison. You are comparing a risky investment with a very low risk investment.
Q(2b) –how much do you agree with this statement; over the long term I am confident I can earn in excess of a bond portfolio and I am comfortable with the risk that would entail?
If you disagree, or are not sure, then add a point, if you strongly agree then take off a point.
Q(2c) – Now a question on investment strategy. If you take the lump sum would you invest the sum mostly in bonds? If yes, then add a point.
Or if you are considering purchasing an annuity – are you using funds that are all invested in bonds? If yes, then add a point.
Let’s now look at a couple of psychological questions relating to fears.
Section 3 - Psychology of Risk
Q(3a)– would you sleep better at night knowing that you had a guaranteed income paying part, or all, of your monthly budget? If yes, award yourself another point. If no, then take off a point.
Q(3b) – Now you might be comfortable managing investments, but is your spouse? If you worry how your spouse might manage after you die and would find a spouse pension useful then add a point.
Q(3c) – would you be unduly worried about your pension plan or insurer failing to make payments, and all the associated guarantee funds and backstops failing? If yes, then take off a point.
Now let’s cover off some last questions on your personal circumstances.
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Section 4 - Personal Circumstances
Q(4a) – Are you in need of your funds in order to make a large purchase. Like a boat, or house? If so, then take off a point.
Ok last question
Q(4b) – Do you want to pass on your assets to your heirs? If yes then take off a point. If you’re not bothered then add a point.
Now it’s time to add up those points. Remember you started with ten points and then added and subtracted based on your answers.
If you got between 9 and 11 points then you are neutral or pretty indifferent between a lump sum and an annuity. If you are thinking of buying an annuity then maybe split the difference and just use half your funds to buy an annuity that pays half the monthly income. If you are being offered a lump sum in exchange for a pension then you don’t lean in any particular direction on this issue – flip a coin.
But if you got 12-15 points you are leaning towards a pension, and if you got between 5 and 8 points then you are leaning to a lump sum.
However, if you got 0-4 points then you should definitely take the lump sum! And if you got 16-20 points then grab that pension baby!
If you really feel that you want to do some math – and hey! I love math as much as the next person – then you will need to put a value on the pension. There is only one actuary-sanctioned method in the blogosphere, my post Valuing a Pension Actuary Style !
If you want some more comprehensive (but somewhat less entertaining) advice from the Society of Actuaries then check out their paper on the subject.
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Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.