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.
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.
"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'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.
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).
Which is why it is smart to change the type of investment as you get closer to retirement.
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.
In any case, whereas 5% might be conservative in the long run, you could be totally screwed in the short term in a bubble.
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 $5,000 would get progressively worse over time.
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.
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.
Today, immediateannuities.com is quoting around $5300 for 65yr old woman and $5665 for a 65yr old man for a $1 mil purchase.