Don’t Undervalue Your Sources of Lifetime Income

Kudos to the American Academy of Actuaries (AAA) for releasing a new Issue Brief
encouraging public pension plan administrators to provide eligible plan
members with certain reference amounts when offering lump-sum
“buy-outs” in exchange for some or all of their pension benefits The
Issue Brief concludes, “members may find the following reference amounts
particularly helpful:An estimate of the cost to replace any benefits otherwise payable in the privatemarket; andThe approximate annual investment return on the buyout amount required to replacethe forgone benefits, assuming an average life expectancy.”In
addition, AAA also encourages disclosure of the assumptions used to
develop the buy-out offer (and also presumably disclosure of the
assumptions used to develop the above reference amounts.)The AAA
Issue Brief includes example calculations for different types of
members. The first example involves a 62-year-old member (sex not
provided) who appears to be eligible for an immediate retirement benefit
of $2,500 per month payable for life with 2% per annum annual
increases. The annuity cost estimate included in the example appears to
us to be somewhat high (even for a female) given current annuity
purchase rates available from Immediateannuities.com, but that doesn’t
affect the points we are trying to make in this post.We have
written frequently regarding the financial advisability of electing lump
sums vs. lifetime benefits, including our posts of:While
the primary focus of these posts was lump sums offered by private
pension plans subject to Section 417 (e) of the Internal Revenue Code
(which provides more protection to plan members than in the public
sector), the comparison concepts are similar. In each of these posts, we
encouraged eligible plan participants to obtain annuity quotes and to
input the two alternative choices in our spreadsheets to see the
potential impact on their actuarial balance sheet and Funded Status.The
AAA’s two reference measures are based on life expectancy (50%
probability of survival), while the default assumptions in our Actuarial
Financial Planner spreadsheet are based on the 25% probability of
survival from the Actuarial Lifetime Illustrator for non-smokers in
excellent health, which produces a lifetime planning periods that are
typically 5-6 years longer than life expectancy. As discussed in our
post of September 14, 2021, we believe that you should plan on living
longer than your life expectancy, and therefore, if your spending
liabilities are calculated based on the assumption of living longer than
your “expected” lifetime, your lifetime income assets should be
calculated on the same consistent basis.The AAA actually agrees with this more conservative planning principle. In its Actuarial Lifetime Illustrator FAQs it says,“If
you plan for living only as long as your life expectancy, you may
outlive your financial resources because there is a significant chance
that you will live longer than that.”Using the default assumptions 1
for the AFP and the data from the AAA’s first example, we calculate the
present values of the example benefits for a male and a female using
the AFP as follows:SexAnnual BenefitDeferral PeriodPayment Period (LPP)Annual Increase rateInterest DiscountPresent ValueMale$30,0000 yrs.31 yrs.2%5%$622,510Female$30,0000 yrs.33 yrs.2%5%$646,589By
comparison, if we had assumed 50% probability of survival for
non-smokers with excellent health from the Actuaries Longevity
Illustrator, we would have developed the following present values:SexAnnual BenefitDeferral PeriodPayment PeriodAnnual Increase RateInterest DiscountPresent ValueMale$30,0000 yrs.26 yrs.2%5%$555,835Female$30,0000 yrs.28 yrs.2%5%$583,6701
Note that the AFP assumes beginning of year payments for income and
expense streams. Also note that LPPs from the current version of the AFP
are 1 year higher for males and females than the current version of the
ALI. The key takeaway from these charts is that if your
personal financial plan in retirement involves living 5 or 6 years
longer than you expect, the value of lifetime income sources increases
significantly relative to your spending liabilities, and this fact
should not be ignored when making planning decisions.Another
reason we recommend using the AFP to facilitate these types of decisions
is because it compares the present value of household non-risky
investments with the present value of household essential expenses,
consistent with Liability Driven Investing (LDI) theory. Pension
benefits are generally considered to be relatively less risky than most
other types of investments, and are therefore ideal for funding
essential expenses. This concept is not totally dissimilar from the AAAs
suggestion that investment returns on the lump sum to make the member
whole be disclosed, as higher implied returns will indicate more risk
associated with the lump sum option.From both these perspectives,
then, it would appear to be pretty clear that unless the member has
reason to believe that his or her LPP is significantly shorter than the
default assumptions in the AFP and/ or she has already sufficiently
funded her essential expenses, the example member should not elect to
receive a lump sum of $293,000 in lieu of her pension benefits under the
plan. Doing so would have a significantly negative impact on her
household balance sheet and Funded Status.ConclusionChoosing
between receiving a lump sum and a life annuity is a decision that
requires some amount of number crunching to get it right. In addition to
the two items suggested by the AAA, we recommend that members (and/or
their financial advisors) input the alternatives in our Actuarial
Financial Planner to see the potential effect on their balance sheet and
Funded Status.