The 6% Rule Can Help You Make the Right Decision

For many Americans the opportunity to have a pension is extremely rare.  The number of pension plans offered has decreased from just over 103,000 in 1975 to under 47,000 in 2017.  These plans are rapidly being replaced with 401(k) plans which have grown in popularity over the last four decades.  However, for those who are so fortuanate, there is a major dilemma of whether to take the pension payout as lump sum or receive  monthly payments.  

The symptoms of the covid-19 pandemic has led many employers to offer retirement packages to soon-to-be retirees and those who are already retired and recieving monthly checks.  So, what is the benefit to the employer for offering a pension payout?  Cost Cutting.  Over the last several months employers in the airline industry have offered buyouts as a de-risking strategy.  Many employers are reducing headcount by offering early retirement packages.  Additionally, offering a lump sum payment as opposed to a lifetime annuity will allow these companies to further reduce long-term financial commitments.  More than 17,000 Delta Airlines employees signed up to take early retirements or buyouts.  The number is roughly 39,000 for American Airlines.  

Lump sum or Annuity Payments? Which Is Best?

First, we must understand that each scenario is different.  No “one financial decision” fits all.  With this being the case, a great starting point is to use the 6% rule when making this decision.  If your lifetime annuity payments offer an annual return greater than 6%, then you should possibly lean towards accepting the payments.  To mathematically address this problem, see the scenarios listed below.  

Scenario 1: $900 a month lifetime payments or $150,000 lump sum.

$900 x 12 = $10,800 divided by $150,000 equals 7.2 percent.

In this scenario, you would make a return of 7.2 percent per year on the $150,000 lump sum payment.  Earning an annual return of 7.2 percent is hard to accomplish on a consistent basis.  In this scenario, the investor could be better suited selecting the lifetime payments. 

Scenario 2: $750 a month lifetime payments or $185,000 lump sum.

$750 x 12 = $9,000 divided by $170,000 equals 4.8 percent.

In this scenario, you would make a return of 4.8 percent per year on the lump sum offer of $185,000.  Earning a 4.8 percent return may not satisfy the retirement objectives of the investor.  In this scenario, it may be advantageous for the investor to take the lump sum payment and invest in a portfolio that can better achieve the retirement return goals.  

Additional items to consider when making this decision are listed below:

  • Your expected amount of time in retirement.  Longevity tends to increase the value of monthly payments.
  • Your age when the monthly payments begin vs. when the lump sum will be paid.
  • Any provisions for a surviving spouse.  Some options allow payments to be made until the surviving spouse passes away.
  • Estate planning and leaving money to heirs.  If you desire to leave money to future generations, the lump sum route will satisfy this goal.

Lastly, it is important that each investor consult a financial professional to dissect their specific situation.  It’s also prudent to consider the economic landscape and the long-term viability of your employer when making the decision to accept the lump sum payment or take the lifetime payments.  

Disclosures

Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. Such an offer or solicitation may only be made by delivery to a prospective investor of formal offering materials, including subscription or account documents or forms, which include detailed discussions of the terms of the respective product, vehicle, service or instrument, including the principal risk factors that might impact such a purchase or investment, and which should be reviewed carefully by any such investor before making the decision to invest. Links to appearances and articles by Paul Z Shelton Jr, whether in the press, on television or otherwise, are provided for informational purposes only and in no way should be considered a recommendation of any particular investment product, vehicle, service or instrument or the rendering of investment advice, which must always be evaluated by a prospective investor in consultation with his or her own financial adviser and in light of his or her own circumstances, including the investor’s investment horizon, appetite for risk, and ability to withstand a potential loss of some or all of an investment’s value. Investing is subject to market risks. Investors acknowledge and accept the potential loss of some or all of an investment’s value. Past performance is, of course, no guarantee of future results. Views represented are subject to change at the sole discretion of Warwick Shore Advisors LLC. Warwick Shore Advisors LLC does not undertake to advise you of any changes in the views expressed herein.

Paul Shelton

Paul Shelton

Warwick Shore Advisors LLC (WSA) is an independent investment advisor focusing on investment strategies designed to outperform the market and mitigate risk over the long-term. We employ a rules-based academic approach that incorporates top-down, macroeconomic analysis and quantitative research. Our rigorous research and portfolio construction process gives us opportunistic insight into the investment landscape. Our rules-based top-down macroeconomic approach differentiates us from traditional bottom-up investment management firms. We believe a global perspective driven on macroeconomics is needed to fully synthesize the current market environment. This approach is also paramount in forecasting the road ahead and building risk-controlled, goal-oriented portfolios.

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