Last Updated on October 29, 2019 at 6:59 am
Arjun had to choose between a two crore lump sum payout and a one lakh a month pension for life. The pension will continue for the spouse after Arjun’s death. What factors should he consider before deciding? Before reading the rest of the article, please make a choice.
This can be a real-life scenario (with variable numbers/features) offered by a term insurance policy or a pension policy or any investment product in general. When members of Facebook group Asan Ideas for Wealth answered this question in a poll, 537 members choose to take the two crores payout instead of the monthly pension.
Two hundred ten members opted the one lakh a month pension option. A second poll was conducted to find out why those who chose the two crore option did so: 165 members thought they would get better returns and 41 cited other reasons out of which inflation was a significant concern. That is, the one lakh a month pension could not combat inflation as it was constant.
In a third poll, the proposer was assumed to be LIC to check if that would make the lump sum group change their mind as the pension is fairly guaranteed: only 28 switched from the two crore option to monthly pension. The two crore option was still popular among 147 members.
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The three polls had different representation, but the significant trends are reasonably clear. Most people would choose the two crore payout because they think they would make better use of the money than receive a monthly pension. What did you choose?
Two Crores in hand or one lakh a month pension: What should Arjun choose?
Arjun will have to recognise that this is not a choice between two future returns. This is a choice between two present risks. Although it is tempting to calculate 6% interest on 2 Crores is 12 lakhs or a lakh a month, where the 6% refers to the annuity from a pension product, the primary considerations need no math.
The two crore payout makes sense because the party offering the monthly pension can default or shut down. Naturally, there are risks in opting for two crores too. Risk of theft (e.g. online fraud), loss of capital, low returns, bad decisions, poor emotional control, high taxation or entry/exit loads etc.
However, the risks associated with the payout are within Arjun’s control, unlike the monthly pension option. Inflation risk associated with the pension is a valid issue but is not as important as the credit risk of the proposer.
One can, of course, argue that choosing a lump sum payout is instinctive – why say no to such money? Why delay the payouts via a pension? It is hard to argue against this, especially if no assumptions of better returns are assumed. However, one must understand there are risks and benefits on both sides.
The concept of “regular pension” appeals to a good chunk of investors, as seen above. However, the risk of the proposer defaulting on payouts should be the primary consideration. Inflation, as argued by those who prefer the lump sum payout, is also secondary.
If LIC is the issuer, then credit risk is practically eliminated, will this impact the choice? It is more than reasonable to assume that the govt will not let LIC fail (or is it the other way around?!). Will this change things for Arjun?
Once the monthly payout is guaranteed, additional considerations come into play as the risk in both options becomes comparable. The monthly payout corresponds to a 6% return on a two crore corpus. Arjun can generate the 6% return with reasonably low risk (before tax, remember pension is also taxable). This, however, not a bed of roses as many seem to assume (see below).
We can do some now, but there is one more issue! The pension is supposed to continue for the spouse after Arjun’s lifetime. If Arjun is unmarried or is a widower, it makes no sense to opt for the pension as Arjun’s nominees (kin or even a charity) will not get even a portion of the two crores back. This can hurt bad, especially if Arjun dies soon after the pensions start.
Without accounting for the time value of money, the pensions should continue for at least 200 months or about 17Y for the monthly pension to make sense. If Arjun and his wife are not expected to live at least 17Y (combined), then the pension option should not be chosen. This is a guess but so is assuming one will get higher returns with the two crores!
If we assume the pension will safely run for 17Y plus, and if eventually, the nominees not getting paid is acceptable then and only then some math can be done. There are two ways to approach this.
One: this one lakh per month for life for the couple is like a minimum guarantee. If their monthly expenses are lower or comparable, this represents income flooring. The retirement corpus necessary to manage inflation will become significantly less, assuming the required amount for this is manageable. See this explanation for details: Creating the ideal retirement plan with income flooring! This option gives Arjun extra money, but the lump sum is lost.
Two: Assume Arjun needs 12 lakh a year for expenses and 8% inflation in these expenses. If the two crore is invested in a portfolio yielding 6% pre-tax and 4.2% post-tax (for 30% slab) and withdrawals made to match the increasing expenses, the corpus will last for more than 13 years. That is a fantastic deal too. Arjun can use the two crores to guarantee inflation-protected income for the first decade and use the rest of his money to build a corpus. This option gives Arjun extra money and/or time – which is more important. See this example for details: Generating an inflation-protected income with a lump sum
Naturally, one can assume higher returns, lower inflation etc. However, when it comes to comparing choices quantitatively, the risk has to be similar, and the return also should be similar. Both become true only when the credit risk is eliminated.
Thus the two crore payout is preferable – not because Arjun can get better returns*, but because he can invest less and/or let the rest of his corpus grow untouched for a significant period of time.
* Higher returns come with risk, are entirely uncertain and can grow beyond Arjun’s control unless he manages it actively. For the same performance, the lump sum payout is more bang for the buck – literally!
The polls mentioned above indicate a tendency of investors to favour extreme thinking. They are either confident (at times overconfident) of doing better than the offer proposed or prefer the safety of guaranteed income.
An annuity offers some less-celebrated benefits. In this case, a 6% return for life is a good deal. When an investor tries to replicate this, there are some known and unknown risks involved.
Achieving 6% return year on year is not as easy a task as it appears. If Arjun eliminates credit risk by sticking to safe issuers, there is always reinvestment risk to worry about. Over a decade, rates are likely to head down, so to compensate some market risk becomes necessary.
The annuity, on the other hand, guarantees this 6% return for life. The price to pay is the capital itself. So each option has risks. Arjun will have to decide which option is more suitable with acceptable risk. Once the issuer risk is not an issue, both options can be evaluated on an equal footing. What will you choose? If you had already voted, will you changer your vote now? Please share your thoughts.
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