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Which Way to Easy Street?
By Karen Hube, May-June 2004
Is retirement cash best taken in a big pile or in small checks forever?
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After 27 years as a worker at an automobile factory, Henry
Mattler, 58, of St. Clair, Michigan, is taking an
early-retirement package. This decision has given him some
indigestion. For starters, Henry and his wife, Dotty, 56, are
arguing about Henry's pension plan. Dotty wants to take it in
a lump sum of $322,900, so they can pay off their $90,000
mortgage. Henry wants to go with choice B: taking an annuity that
will pay $1,950 monthly for life, starting now.
Strengths
Henry's package includes lifetime health insurance for the
couple and a payout of $27,500 (above the pension). Their house
is worth $240,000, and they have $80,000 in IRAs. When
they're 62, Henry can start collecting $1,090 and Dotty can
receive $545 monthly from Social Security (Dotty didn't work,
so she's eligible for an amount equal to half of Henry's
check).
Weaknesses
The Mattlers have too little saved for retirement; they're
nearly $50,000 short of what they'll need (about $36,000 a
year), assuming they live into their 80s. Also, they keep their
investments very safe (and low-yielding as a result), with just
35 percent in stocks and the rest in bonds and CDs.
The Plan
The Mattlers need to stop bickering about Henry's pension.
Sorry, Dot, but the annuity is their best choice. Why? The
Mattlers face a long retirement and are at high risk of running
out of cash, says Lynn Ballou, a certified financial adviser in
Lafayette, California.
For other couples—especially those who are older or
unlikely to outlive their savings—taking a lump sum could
be wiser, says Bill Arnone, a partner and pension specialist at
Ernst & Young. Timing is a factor: when interest rates are
low, as they are now, lump-sum payouts tend to be larger. This is
because pension plans calculate the annuity payments first and
then figure the equal lump sum using today's interest rates.
At the current 5 percent rate, Henry's lump sum is $322,900.
But if the rate inches to 6 percent, it would drop by nearly
$30,000, says Jerrold Levy, actuary at Mercer Human Resource
Consulting in Chicago.
Still, the lump sum isn't wise for the Mattlers. It would
need to generate more income than the annuity, and given their
timid investing style, that's unlikely. "It's also
easy to blow a lump sum," adds Arnone. Someone might decide,
"Let's buy that boat we've wanted." An
annuity's cash is guaranteed.
Further, applying the lump sum to their mortgage would be costly;
cash not rolled into an IRA would be taxable. And a
mortgage—especially at their rate of 5.9
percent—isn't a terrible thing. "Come tax time
each year, that mortgage deduction is very welcome," says
Ballou. "Thou shalt pay off all debts" doesn't
apply to a low-interest mortgage; it's as close to free cash
as you'll ever get from a bank (legally, that is).
The Mattlers must build their retirement savings or they're
in for trouble. They could cut costs by about $5,000 a year, but
that would mean big sacrifices. The best bet might be for Henry
to take another job and retire in a few years, says Ballou.
Taking Social Security at age 66 would increase his monthly
payments by $440, up to $1,530. Dotty's checks will also
increase if she waits. A financial planner can help reshape their
investment portfolio to generate more growth. "They need an
average annual return of 7 percent," Ballou says. With these
steps taken, Henry and Dotty can argue about other matters, such
as whether to take the Alaskan cruise or Bermuda trip.
Karen Hube, our new money columnist, has written for The
Wall Street Journal. She lives in Westport, Connecticut.
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