Sue Stevens, CFA, CFP, CPA
A discussion of annuity options and withdrawal strategies.
Tom and Mary Wilson (ages 55 and 53, respectively) know how to deal with adversity. She is in her fifth year of remission from breast cancer and he just learned last fall that he has early-stage leukemia. If managing their health issues weren't enough, now they are faced with an early-retirement offer from Tom's company, where he's worked for more than 30 years. If he doesn't take the offer, he faces the real possibility that he may be laid off anyway.
Tom and Mary aren't alone. With the economy still shaky, many companies are continuing to look for ways to cut costs. Early-retirement packages are often the answer. If you are trying to evaluate an "early out" program, read how we analyze Tom and Mary's situation and see how you can apply the same principles to your own life.
Exploring the Possibilities
Retirement planning is quite complex. You need to consider all kinds of issues including life expectancy, rates of return, inflation, expenses and how they might change, health factors, and perhaps even the possibility of working part time. Working through the calculations on the back of an envelope just won't cut it. At the very least, use some kind of online calculator to help you through the process. For many people, however, retirement planning is one of the most important reasons to seek out an experienced financial planner.
When I work with my clients, we begin by building a realistic "Base Case" with retirement-modeling software. From the Base Case we can go on to create multiple "What If" scenarios: What if inflation goes up?; What if investment returns are in the single-digit range?; What if I took the annuity versus the lump-sum option?. Typically a company will give employees several weeks to evaluate an early-retirement package. Don't wait until the last week to get help!
Tom and Mary are considering building their dream home. They also hope to travel a bit and spend time getting to know their grandchildren better.
Choosing an Annuity or a Lump Sum
This can be one of your biggest decisions when evaluating a retirement offer. Don't make the mistake of following the crowd and doing whatever your friends do. If you want to learn more about pension dos and don'ts, click here.
Health history can play an important part in choosing what option is right for you. If longevity is in your gene pool, the annuity ensures you'll still have a steady income no matter how long you live. In Tom and Mary's case, although they are very optimistic about their futures, the lump sum offers the best chance of passing wealth to the next generation.
Running the Numbers
You can't meaningfully plan retirement without crunching some numbers. We ran three scenarios to help the Wilsons recognize their options. Scenario One assumed they took the lump sum and invested it to earn a 7% rate of return. Scenario Two assumed they took an annuity that would not decrease should Tom die prematurely. Scenario Three showed what would happen if Tom continued to work until age 58 and then had to take an annuity. (His company offers only the lump sum through the early-retirement package.)
| Net Worth through Retirement ( $ ) | ||||
| Scenario | Age 55 | Age 65 | Age 75 | Age 85 |
| 1: Lump Sum | 1,716,300 | 2,049,034 | 1,894,900 | 374,800 |
| 2: Annuity | 1,318,800 | 1,870,700 | 2,287,300 | 1,732,489 |
| 3: Work Longer | 1,310,500 | 1,879,800 | 2,010,400 | 896,500 |
When we compare the numbers, the annuity looks like the best option at age 75 or 85 for this couple. But what if one of them dies prematurely? At age 55 or 65, the lump sum looks like their best option. In the near term, working longer doesn't appear to help this couple.
When you run your own numbers be sure to look carefully at assumptions about inflation, rates of return, expenses now and in the future, health-care costs, and tax rates.
Sequence of Withdrawals
If you are retiring before age 59½, you'll need to have a plan to avoid the 10% early-retirement penalty. For most folks, partial withdrawals from their 401(k) or 403(b) plans are the answer.
If you are age 55 and separated from service, there is no 10% penalty for withdrawals from qualified company plans (not so for IRAs). But in Tom and Mary's case, their company does not allow partial distributions. It's all or nothing--they have to take it all or leave it.
Tom could consider substantially equal periodic payments--so-called 72(t) distributions--from his IRA for the greater of five years or until age 59½. That would allow him to bypass the 10% penalty. But he also has an employee stock ownership plan that holds company stock. Tom's best option is to take out the stock from the plan, pay ordinary income tax on the basis (the company will provide this figure), and hold the shares. Then when he sells those shares, all appreciation above the original basis will be taxed at capital gains rates.
For more on smart ways to tap your retirement accounts, click here.
Don't Forget Health Care
Perhaps the most important part of any early retirement package is health care. Does your company offer primary coverage until you are eligible for Medicare? If the former employee dies before he or she is Medicare-eligible, what happens to the spouse's health-care coverage? You'll need answers to these questions before you can adequately weigh the early-retirement option.
In Tom and Mary's case, his company did provide adequate retiree health-care coverage. But we built in a higher inflation rate for health care in their retirement plan than we did for other types of expenses. Medical coverage is one of those expenses that can easily go up in retirement. In many situations, long-term care insurance should also be part of the solution.
Ease on Down the Road
One of the biggest trends today is a gradual phasing into retirement. Say goodbye to the long hours and high pressure. Retirement can mean doing work you enjoy more, and doing less of it! Experiment with jobs you've always wanted to do. Explore the possibilities of volunteering. Retirement should bring you freedom to live life on your own terms so you can make the most of every day you're given.
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