Lump sum or monthly payment: which is best?
This is the latest in the Bermuda Realistic Retirement Review series, published on the third Saturday of each month.
Is a bird in the hand worth two birds in a bush?
Another reader FAQ, with a hypothetical illustration for confidentiality.
“Hi, I'm approaching my 65th birthday, still working, and after a messy divorce, on my own for retirement. Just recently applied for the Bermuda Contributory Pension. The nice folks up at the Department of Social Insurance informed me that as I had only contributed for 15 years, I was not eligible for a full pension.
“My two options are:
“1. A lump sum of $35,000 now.
“2. A monthly payment of $200 for my remaining life.
“Maybe it is me, but I just can't wrap my head around this, except to say that I want to get every penny I can. Fortunately, I do have other savings, and intend to work for as long as possible to keep health benefits.”
All right, readers, what do you think? This is a straightforward math calculation. Our reader's mother still vitally active at 95 means that our reader, too, may have the Bermuda longevity gene.
• We project that our lady lives to 100 years old = 12 months in a year x 35 years x $200 a month equals the grand sum of $84,000!
Great. A no-brainer decision. $35,000 now compared to payments over her lifetime of $84,000.
But, is it?
What have we forgotten? Here is where realism steps in.
Six very important points
1. First, we review the inflation effect on purchasing power.
2. Then, we need to compare apples to apples, by setting the current lump sum amount next to the total payments — discounted back to the present time, following with;
3. The emotional and physical lifetime decision.
4. Trust in Government and its ability to pay.
5. Risk of loss in investments.
6. Conjecture of future events such as a possible implementation of a tax on pensions; reduction of payout amount; devaluation of currency, redundancy, medical health issues.
Inflation and purchasing power
In reality, $84,000 total in the future cannot be reasonably compared to $35,000 in the now. A monthly $200 payment will not buy the same amount of groceries, next year and as each year rolls around her purchasing power value will decrease further. We all know how quickly food prices tend to escalate — imagine how little food you can purchase in 20 or 30 years with $200.
What about we calculate all those the future payments, but discount them as if they were paid out today (their present value) by using an inflation factor (say 1.5 per cent) which is probably close to pension increase, although not always annually.
Apples to apples comparison
To do this, we use a math function called “the present value of an ordinary annuity calculation”. This function is used to determine the total cost of an annuity if it were to be paid right now. What many may not realise, too, is that this calculation is important in legal and other financial settlements, actual annuities, contracts, and the like.
PV of an annuity math is also taught in school — utilising formulas the old-fashioned way by hand.
We, however, will cheat by using an online calculator. https://financialmentor.com/calculator/present-value-of-annuity-calculator
Now what do we see:
Lump sum distribution today of $35,000 compared to present value of the monthly payments, $65,320. Sounds terrific, doesn't it? Almost twice as much, just for living to 100!
Caveat — but, we cannot get the total annuity payments today, can we?
This is where the other four very important factors come into play.
Emotion and physical decisions
What if our reader's longevity is associated with her father, who passed at age 75? The present value in ten years of her pension payments is $22,273, significantly less than the lump sum number. Further, what if she has a mortgage and no emergency fund? These decisions will only become more difficult as she ages.
Trust in the payer government
Perhaps, our reader is confident in her great physical health, thus, finds the monthly payout more appealing. Can she rely upon government to meet her pension requirement for 35 years? Actuaries recently stated that the Contributory Pension Fund will run out in 2049 — that's only 30 years away. Plus, readers, we do not know the interest rate used to calculate this projected government liability.
A higher interest rate, say 7 per cent return on investment, generates a much lower pension liability, than a more realistic 3 per cent interest rate (the current coupon rate on 30-year US Treasuries). Could the fund run out sooner?
Investment risk and loss
Suppose our reader decides upon the lump sum. She is comfortable with investments, and feels that she can do far better than the 1.5 per cent inflation rate adjustment that Government provides to pensioners. Plus, her Bermuda dollar lump sum will convert to hard US dollar currency. So far, so good.
Based upon the historical average in the last ten-year return of the US S&P 500 index of 10.74 per cent, for instance, she could more than double the $35,000 in ten years, then take small distributions monthly, while her investment fund continued to grow. The reward is that the investments may return even more than 10 per cent plus, or in a negative, worst-case scenario, her fund descends to a risky loss basis with no recourse to recovery!
Risk of future adverse events
Could pensions be taxed under more government reform — after the notional tax initiative? What if the Contributory Pension Fund gives everyone a haircut (reduced pension) “down de road” due to continued high debt levels? Could the value of the Bermuda dollar be adjusted downward by markets or decree? Could she experience redundancy, needing immediate cash, or retire completely due to medical impairments?
They are the facts. Decisions, decisions.
Each strategy should be weighed carefully!
Readers, which option would you choose?
The Present Value of an ordinary annuity: https://goo.gl/j1BK9w
The calculator at Financial Mentor, Financial Freedom for Smart People: https://goo.gl/HsBJUF
Next week: Matters of special importance, part two of the Auditor-General's Report on the Bermuda Government Consolidated Fund, 2013-2016.
• Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Personal finance columnist to The Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: email@example.com
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