EMPP Lump Sum or EMPP Annuity? - 3 Issues to Consider

If you opt for an annuity, recognize that you’ll receive taxable income every month, taxed at ordinary income tax rates. Your marginal tax rate may decrease between retirement and when you begin taking Required Minimum Distributions (RMDs) from your IRA. So, for those years, you may be okay paying taxes on recurring income you will use to live on.

On the other hand, we find many ExxonMobil retirees at retirement with large IRAs. They may want to avoid recurring annuity income on top of RMDs, driving up their marginal tax rate when they’re in their 70s and 80s. Yet, that’s what an annuity can do.

“But,” you retort, “if I take the lump sum, won’t I likely roll that over into an IRA and generate even larger RMDs after I have to begin taking them?”

Yes, that’s true. The lump sum, if rolled over and left in the IRA, will increase the value of the IRA and your RMDs. But rolling it over at retirement into an IRA gives you flexibility on when and how much you might pay in taxes. If you’re 59-1/2 or older, you can take distributions from your IRA without penalty, paying only ordinary income tax. Many clients will use those years between retirement and RMDs to do Roth conversions, rely on IRA money to enable them to postpone starting Social Security, or take cash out of the IRA at tax rates lower than what they envision down the road.  All these strategies would reduce the balance of their IRA subject to RMDs when they start RMDs at age 73 or 75.

In summary, lump sums can give you more control over when and how much taxes you pay.

Good financial advisors worry for our clients about “sequence of returns” risk.

Suppose you take the lump sum, invest it in the stock market, and the market promptly encounters a miserable economy and crazy geopolitical turbulence.  You’ve experienced an immediate paper loss of 30% to 50% of your portfolio. Remember early 2020, all of 2022, or the bear market of 2008-2009?

Yes, the market will likely come back over time, but in the meantime, you’re living on diminished (and diminishing) assets. You may not have sufficient assets left when the market does turn around to rebuild your nest egg to what you need to sustain your lifestyle.

You’ve run into a poor “sequence of returns.”  Poor market results early in one’s reliance on retirement assets to live on can sidetrack plans.

That hypothetical scenario can be a retiree’s worst fear and a major justification for taking the annuity. And If you (or often, it’s your spouse) are particularly risk averse, an annuity that doesn’t depend on the market to cover basic living expenses may be the correct option for you.

But there are ways to mitigate this danger other than taking the annuity. You can keep a portion of your lump sum in cash, tradeable money market funds, or short-term bond funds which should remain relatively stable if equities take a nosedive. Live off cash or “near-cash” for a year or two or three while the market recovers.

Another option is to invest in the market slowly. Diversify globally, not just in the S&P 500 or domestic securities. Having cash to invest when the market does go down can provide great returns.

In summary, when considering how to take your pension benefit, it’s wise to contemplate the implications of your choice through the lens of several scenarios, not just what you’ve most recently lived through.

Some investors worry more about declines in the stock market than about the loss of purchasing power resulting from pulling out (and staying out) of the market.

Faced with the prospect of investing a lump sum pension benefit, folks may fearfully conclude that they do not want to risk the “loss” (on paper) of a market correction. A fixed annuity, insulated from the ups and downs of the stock market, provides a soothing sense of control and security.

That sense of security needs to be balanced, however, by recognizing what inflation over time does to the purchasing power of that annuity.

The chart below shows the future purchasing power of an annual annuity of $100,000 beginning in 2023, as inflation makes things more expensive over time.

For example, your $100,000 in 2023 will be worth only $61,027 in 20 years if we run consistent years of 2.5% inflation. Looked at alternatively, to maintain the purchasing power of $100,000 in 2023, by 2043, you’d need $100,000/$61,027 or $163,860 in 2043 dollars.

For simplicity, we’ve assumed a constant inflation rate, ranging from 2% per year (the Fed’s target) to 3.5% per year (near current inflation rates). The math is straightforward, and the results are likely surprising.

In summary, if you opt for an annuity, consider your strategies to protect your purchasing power when you’re older. Don’t assume you won’t live long enough to suffer the compound effect of inflation.