Would You Rather Have $1M or $5,000 Monthly in Retirement?
wsj.com
wsj.com
I might make a different choice if it was between the two amounts with no strings attached (i.e not necessarily for retirement), so I could invest a bit more aggressively and keep working.
A pretty poorly constructed example for WSJ I think
Your risk in that scenario is long term care needs. That will drain your savings until you're poor enough to move to Medicaid. Another good reason to take the $5,000
However, if your below 70 and in very good health the 5k/month is probably a much better bet.
A life annuity is one where up front you pay $X, and for the rest of your life you get $Y at regular intervals. They're comparing what someone would pay out on a $1,000,000 life annuity.
This is different than the 4% safe withdrawal idea because you're drawing from the principal all the time not just the interest.
Companies offer this because they expect you to die long before the principal runs out and then they get to keep what's left of it. Or, maybe you live longer than that and they have to pay more than what the initial investment earned them.
Like other forms of insurance, they're probably going to make money on you. Unlike health/car insurance, this type isn't legally required or usually a good idea.
2) Is balanced by the upside risk that I live to 117 and run out of money. And frankly, I'm much more worried about that than I am about stiffing my heirs (at least once college is paid for).
3) If you had $1M and withdrew roughly 4% for the rest of your life, there's also a decent chance it would be worth a lot less than $1M when all is said and done and you're eating capital. Remember, you're no longer a long term investor, you can't ride out ups and downs, you have to keep paying the bills during down periods, excaberating your losses.
I'm firmly of the belief that annuities are one of the best types of insurance you can buy.
I don't know about you, but most people in my social circle intend to retire between 55-60 and that leaves 25-30 years of retirement, so definitely still in the long term investing range.
When I retire, I don't plan to adjust my investments until I get past 80.
Model it yourself, calculate what a 30% drop in the stock market next year would do to your portfolio. If you're a long term investor, an 80/20 stock/bond split makes sense.
But if you regularly withdraw 4% of original capital inflation adjusted, a model that incorporates the possibility of a 30% drop will show you why you need more bonds.
And show you why 4% is unrealistic and why a 5% annuity is a good deal.
The company might make a lot of money off you. But, they might lose a lot of money if you live too long. The risk is transferred from you to them, and you live with a specific fixed income for the rest of your life, however long that may be.
You don't worry about the economy going up and down or interest rates rising and falling. You don't worry about living too long and running out of money. You don't worry about living too little, and dying with most of your money still in the bank. You stop worrying about the future.
Sure, the math may add up to "that company is making a bit of money that you might have made", but when I retire I want to not give a shit about the future anymore. That's why it's a good deal, to some people.
You can probably also spend more windfall given 1M investment rather than 5k. With the annuity, you would be smart to reinvest any excess, but you also cannot overdraw if needed, e.g. for medical reasons. You would have to go for debt and lose money.
My actuarial life at that point can't be very long, so it shouldn't be too expensive. It's a good way to manage tail risk in case I do live to 100+, and will allow me to spend the rest of my capital more freely knowing my base expenses are covered for life between the anuity and social security.
The $5,000 would get progressively worse over time.
But more importantly, $1M lump vs $5,000 monthly annuity, always take $1M. Why? Because you are taking an asset class that can be converted into shares/bonds which has a higher expected returns than an annuity because it can compound.
What I mean is while the $5,000 annuity is guaranteed, it will remaing $5,000 year-over-year, which means it's actually decreasing in purchasing power year-over-year (unless there is deflation, which it's very unlikely). Wereas the $1M cash, if moved to bonds and shares, even if it performed at 5% annually, it will mean on the first year break even, but on the second year it will compound (unless you spend all the money). You could say you invest the monthly savings from the $5,000 but simply put it, $1M in shares has a much higher expected return than $5,000 monthly in perpetuity.
Which is why it is smart to change the type of investment as you get closer to retirement.
In any case, whereas 5% might be conservative in the long run, you could be totally screwed in the short term in a bubble.
"First, the safe withdrawal method of 4% is actually not safe - the safest method of withdrawal is called variable percentage withdrawal and not only takes into account the principle, but also the results year after year."
This is an argument for taking the annuity. When two options have the same expected value, volatility is a bad thing.
"Because you are taking an asset class that can be converted into shares/bonds which has a higher expected returns than an annuity because it can compound."
The author writes under the pretense that the $5K figure is EQUAL to the risk-adjusted rate of return on a $1M principal. Sure, there are asset classes that have higher expected returns than a guaranteed annuity, but that is because they are RISKIER. Obviously, people value risk differently, which is why in general, you can't say "always take $1M"
"Whereas the $1M cash, if moved to bonds and shares, even if it performed at 5% annually, it will mean on the first year break even, but on the second year it will compound (unless you spend all the money)."
The whole point of the $5K figure is that it is the same amount as the risk-adjusted return on a $1M investment. How the user chooses to spend that $5K monthly sum is up to them and they have the freedom to spend or invest that sum in the same manner regardless of which option he/she takes.
"You could say you invest the monthly savings from the $5,000 but simply put it, $1M in shares has a much higher expected return than $5,000 monthly in perpetuity."
Incorrect for the above reasons.
Assuming that $5K/month annuity is the expected rate of return on a $1M invested in a risk-free asset class (which is the assumption this article is written on) and you have the option to cancel the annuity and retrieve your principal at any time, it's pretty clear that the annuity is the better option because it has NO volatility.
The reality is that an annuity comes with lower volitility and risk.
When you look at the risks for a retirement payout, you need to think carefully. How long will you live? How long will you retain your faculties to manageme investments? What protections do you have against dishonest or incompetent advisors?
Unless you're unlikely to live long, or have trustworthy children or other advisors, the annuity is probably the best scenario.
But as you said just because the expected is higher doesnt mean the actual will be. But you still should always pick whatever has higher expected
You can almost think of risk as currency, i.e. each addition unit of risk opens you to strategies with higher expected return. But you can also access strategies for which you're able to "pay" the risk (basically fits into your tolerances).
You're missing the problem of sequencing of returns. If you made that decision at 65 years old in December of 2007, you would quickly regret it unless you were one of the small percentage of people who can take the massive volatility that followed over the next 15 months.
You ABSOLUTELY MUST take into account the risk. Not doing so would get your sued as a financial planner. Frankly, this is where people lose so much of their savings is listening to hogwash like this.
Go spend some time and get your CFP or CIMA certification and then come back, and your answer will have changed.
And if I sound ticked off, it's be cause I am. you are totally ignoring Behavioral Finance, which is much, much more important than simple math.
Personally, I would take your money for a guaranteed 5% and invest it in more risky funds, covering the losses or taking the excess gains.
The annuity can compound too, if you treat it like you would any other 6% dividend and reinvest it.
Once you see that, the two become almost functionally equivalent. It comes down to a liquid million dollars with market returns or an illiquid million dollars with a guaranteed 6% return.
Which is better comes down to luck. If its 2006 and stocks are at all-time highs, then the 5% guaranteed will definitely return more over 10 years, and maybe over 20 and 30 years. If it's 2009 and stocks have cratered, the liquid million in the market wins handily.
The liquid million has a slight edge in expected value, as 7% > 6%. But when you consider the 6% is a lower bound and the 7% is an average, it becomes clear that there are situations where the guaranteed income stream could win.
Today, immediateannuities.com is quoting around $5300 for 65yr old woman and $5665 for a 65yr old man for a $1 mil purchase.
Why? Because otherwise I have to trust some entity to keep paying me $5000 perpetually in my retirement. Thats hard to do with any entity involved - government, my employer, financial companies... virtually any entity can face a downturn 3-4 decades from now and decide to default on their obligations.
Better to pocket $1M and invest it myself. There is less chance of prudent investments going wrong over 3-4 decades or any entity seizing those assets (because if any of that were to happen, I would have much bigger problems).
Of course, those things might have a very low probability of happening, but there is also a low probability of a well-diversified portfolio from being wiped out.
$1 million is 16⅔ years of $5,000 a month. The cumulative rate of inflation since 2000 has been -29% [1]. That $5,000 would buy today what $3,500 bought then.
Also, keep in mind that someone is paying you that $5,000 a month. They could go bankrupt one month into their obligation to you. Inflation risk, foreign exchange risk, counterparty risk and tax consequences are just some of the risks one would need to consider when weighing lump sums versus annuities.
It is close enough.
1/(1-0.29)=1.4
Depends on if you are going back or forward in time.
Let's assume that it's all post-taxes money (both the 1M and the 5k/month) and let's calculate how good of an investor you'd have to be to take the 1M.
For this, every month you should get more money than you spend. Assuming a cost of life of $5000 this would yield:
1,000,000 * (1 + x) > 5,000 => x > 0.005 => x > 0.5%
Which in turn is ~6% anually (we can approximate it since 5000 / 1.000.000 ~ 0). So if you spend $5000/month, you'd need to get a return of investment larger than 6% annually.
Now let's say that you move to a cheap but nice country and you get expenses down to $1000/month. After 1 year you'll have saved $48.000, which in turn you can start to re-invest.
Of course this is totally theoretical, and many people would just take the 1M, overspend it and then complain. Apparently many lottery winners are dead or bankrupt: https://www.reddit.com/r/AskReddit/comments/24vzgl/you_just_...
Terminal cancer and hospice by 70? How do you want to spend those last 6 months, and what's the value in having an active role in directing what would be inheritance towards those people and causes that matter most to you?
Major unexpected medical issue with a spouse or loved one that requires support beyond basic govt coverage? Maybe you want the option to tighten your belt a bit more that last decade so you can make a difference now.
Have a positive experience with parents or grandparents at end of life? Or an unnecessarily difficult one?
How about the economic situation of other family members and cultural expectations and family history when it comes to caring for elders?
Sure, every financial possibility can be offset by another, and maybe annuity pricing equates $1M lump sum to $5k/mo. But reducing all the personal values that go into someone choosing one vs. another as an illusion of wealth or poverty seems so absurdly academic and out of touch with the basic humanity we each have.
If you get disabled (cannot do 2 of 6 daily functions), you can draw from the death benefit, when the death benefit is exhausted you can draw from the LTCI pool.
So if you have money saved up, it makes sense to use some money to get protection. Otherwise disability at old age can use up a lot of money.
If you don't use it there is cash value that can be used (it grows along with the death benefit) or passed on.
Also due to inflation $5000 today might be worthless in 10 years, so it would take more than 16 years to get the same ammount of cash. Considering you retire at ~65 would be one more reason in favoring the $1M.
Is that really still true nowadays?
I'll retire at 55 with a pretty good annuity payment. It's not zero risk, but pretty secure.
Then, what would the high end of the second range need to be to get you to change your mind (assuming the low end is fixed at zero)?
I'm not in need of that much money, so the 1 million guarantee is not valuable enough to me to offset the fact that I would have 50%+ chance of getting something more than 2.5 million.
high end of $2,100,000 on the second case is enough for me to switch to the second one.
500K? 100K?
If you're already comfortable, the random amount has a better expected return.
I guess another interesting question instead of adjusting the range of the random outcome would be to scale the whole thing. Say you'd take the million. What about 10k vs 0-50k? My expectation is that the responses would be more consistent (ie less dependent on size relative to net worth) than you'd think.
I'm ok with this :-)
The packages some of these municipal employee's get for retirement are amazing.
It's a vaguely similar advantage to taking out a reverse mortgage.
I'd back myself over the next 20 years to turn that $1M into something worth considerably more. If I made a mess of it, I'd still hopefully have enough productive years left to salvage the situation.
Whereas $5,000 per month is $5,000 per month forever. Unless you can live substantially under that amount and save a good chunk each month, you're never going to have capital to really grow.
Even though by any logical metric I was far less of a risk than someone living paycheck to paycheck, the situation was outside of their regular mold, so they considered it risky.
There are a lot of Dallas Firefighters and GM employees and many, many others that took that bet and it came up short.
Nobody is insulated from risk.
However; there are so many factors that could push me to decide that $1M would be better.
I don't think it would help me personally to see a Monthly projections on my retirement accounts. In fact, I trust monthly projects less because I've seen my 401K projecting a huge per month number when I was contributing a miserly amount of my pay check. I wonder whether they were straight up lying or assuming my salary and contributions would increase.
The thing about projections is that there are so many factors that the investment companies don't know about me or my plans. They don't know when I'm planning to retire, what my budget is, what other investments I have, what I expect to make in the future, or what risks I'm planning for.
If people have as much information as there exists today and they make bad decisions, changing it to monthly projections won't solve their problems. It might create more.
A 6% return is not equivalent, because a 6% return would still leave you with $1m at the end of the day (or your life). An equivalent return for a 25 year period would be about 4%, and I defy you to find a diversified portfolio that can't return 4% over 25 years...
Besides, if the pitch is "wait 25 years and then some organization will pay you $5,000 per month", then we have to assume that this organization will still exist in its current form that far into the future, that it will still be capable of making good on the $5,000 commitment, and that it will still be willing to do so, and won't have gotten acquired or gone bankrupt or otherwise restructured itself in a way that frees it from its previous obligations. Political and economical environments are always changing, so I would definitely rather have real money now than hypothetical future money which depends on someone else's future organizational continuity.
plus if we consider inflation 1000 000 on day 1, worth a lot more than in 16 years
So I would say ... take the 1M
Given the choice today, I would take the first. It's such a high spread over today's US actual risk free rate (10 yr UST as proxy) that you'd have to guarantee generating the same ~3% spread over historical broad market returns (I.e. 9% or so) to justify passing up the 6%.
Also, I had a dream when I was younger that I'll die when I'm 73 and my lifestyle generally points to the sense in not assuming too many years beyond retirement age, which here in Blighty might hit 70 by when my time comes around.
- ed
I'm not 40 yet, so waiting for literal decades before some speculative pay off seems like too hard-headed a form of sense to fit my character!
Other criticisms are mentioned elsewhere in the thread; overall a pretty sloppy and incoherent article.