Lump Sum or Annuity?

By James Kwak

Usually the New York Times gives reasonably good financial advice—or, at least it avoids giving really bad advice. Today, however, Paul Sullivan’s column borders on the latter. The question is whether to take a pension payout as a lump sum or as an annuity (a guaranteed, fixed amount per year until you die).

Sullivan’s column isn’t all bad. He talks about the importance of being able to manage your money and the need to be comfortable with risk if you take the lump sum. He also points out the annuity (in this case, based on what GM workers are being offered) isn’t indexed to inflation, which is an important consideration. And he doesn’t come down on one side or the other, although he says he would take the lump sum because, he says, “I would rather control the money myself.”

But there are some serious problems with his discussion. One is the way he discusses control as a good thing. Reams of empirical research have shown that, for the typical individual investor, control is a bad thing. Here’s just one fact: from 1991 through 2010, investors in stock mutual funds earned an annual return of 3.8 percent, while the S&P 500 earned an annual return of 9.1 percent. That’s because investors tend to buy high and sell low (based on past performance), and because they generate transaction fees through excessive trading.

This is a case where individuals are better off tying themselves to the mast, like Odysseus before the Sirens, and making it impossible for themselves to make dumb mistakes. Unfortunately, human beings suffer from optimism bias, so most people think they can do better than the market.

The bigger thing that’s missing, however, is a serious discussion of risk. For the purposes of comparison, start by assuming that the conversion between lump sum and annuity is actuarially fair. (If it isn’t—if, for example, the expected value of the lump sum is much higher than the expected value of the annuity—then that will be a major factor. But that’s not something that the typical individual is going to be able to figure out on her own. And more on that later) In that case, you are being offered two things with the same expected value. But one has much higher risk than the other: your average annual retirement income is highly volatile with the lump sum, while it’s known with certainty with the annuity. Basic finance dictates that between two things with the same expected value, the one with lower risk is better.

Now, some people think that the “risk” is that you will die young and you will lose on the annuity; the lump sum, by contrast, exists today, so it has no risk. But that’s the wrong way to think about it. When it comes to retirement income, the most important priority is making sure you don’t run out of it. The thing you really care about is not cash in hand today, but either your average income in retirement or your minimum income in retirement. An annuity guarantees you won’t run out of money; a lump sum doesn’t, and that’s a lot of risk you’re taking on.

So it only makes sense to take the lump sum if the expected value of the annuity is lower than the expected value of the lump sum—and the more risk-averse you are, the bigger the gap has to be. One reason the EV of the annuity could be low is if you know you are likely to die early. Leaving that aside, however, it’s hard to see what rational basis any retiree could have for thinking that the EV of the lump sum is much higher than the EV of the annuity.

If you want to do the calculations, you can’t assume a 10% return, or an 8% return, or even a 4% return on investing your lump sum. You have to assume a risk-free return (since the annuity is risk-free), meaning the yield on Treasuries of appropriate maturity (ten years is probably about right as an average for a retiree in her sixties, who is likely to live twenty more years), meaning about 1.5%. At that yield, I suspect that most GM retirees could not convert their lump sums into the annuities that they are being offered.

Besides, we know what happens when people take lump sums at retirement: just look at West Virginia (although the problems there went beyond just lump sum payouts). It isn’t pretty.