Pension Election, Long-Term Care, and Sequence Risk
Ben, 64, and Lisa, 62, are both retiring in June. Ben must choose between a $720,000 lump sum and a joint-and-100% survivor annuity of $42,000 a year, no COLA. They have $1.3 million in a 401(k), $250,000 Roth, and a $180,000 mortgage at 6.5% with 12 years left. Their spending goal is $110,000 gross; Social Security at 70 will cover $58,000. Neither has long-term-care coverage and Lisa's mother spent four years in memory care. Ben's father lived to 94; Lisa's father died at 69 of a heart attack. Ben is in good health, Lisa has controlled type 2 diabetes. Their current allocation is 72/28 and they say they 'can't stomach another 2008.'
1. Evaluate the lump sum versus the annuity. What would change your recommendation?
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Start with the payout rate: $42,000 / $720,000 = 5.83%, which is high relative to a commercial annuity, so the annuity is competitively priced.
Rough present values of $42,000 for 25 years: at 4%, 42,000 x 15.62 = $656,000; at 5%, 42,000 x 14.09 = $592,000. At a 4-5% discount rate the lump sum is roughly fair or slightly generous. The annuity wins if they live past roughly 22-25 years or if they would invest the lump sum poorly.
Key risks of the annuity: no COLA. At 3% inflation, $42,000 has the purchasing power of about $23,000 in 20 years. The joint-and-100% survivor feature protects Lisa, which matters if Ben dies first.
Key risks of the lump sum: sequence risk and behavior. They describe themselves as unable to stomach another 2008 while holding 72/28, which is a warning that they may sell at the bottom. The annuity removes $720,000 from that behavioral risk and provides a floor.
Recommendation: take the annuity as a base-income floor if the pension is PBGC-covered and the employer is sound, because it covers 38% of spending, protects the survivor, and matches their stated risk tolerance. Then invest the $1.55 million more conservatively. What would change this: a materially impaired health outlook for both, a pension that is not guaranteed, or a need for liquidity to pay off the mortgage and fund care. If any of those dominate, take the lump sum and build a TIPS ladder instead.
2. How should they address the long-term-care exposure?
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Quantify before buying. Memory care in their area might run $120,000 a year; four years is about $480,000 in today's dollars, more with inflation. Their investable assets are $1.55 million plus, if taken, the $720,000 lump sum. They can self-insure one severe care event, but not two.
Options:
- Traditional LTC policy: at 62 and 64, premiums are meaningful and can rise; underwriting for Lisa's diabetes may result in a rated policy or decline. Check before assuming availability.
- Hybrid life/LTC or shared-care policy: a single premium or limited-pay structure with a death benefit if care is not used. This suits them because it uses capital rather than an open-ended premium stream.
- Self-fund with an earmarked sleeve: set aside $400,000-$500,000 in conservative assets and treat it as a care reserve, not part of the retirement portfolio. This is simple and avoids underwriting.
Recommendation: price a shared-care hybrid first, and if it is uncompetitive, earmark a self-funding reserve. Do not buy a policy that consumes so much cash flow that it threatens the $110,000 spending goal. Also confirm whether their state has a partnership program that protects assets if Medicaid is eventually needed.
3. Given their stated risk tolerance, what should the allocation and withdrawal sequencing look like?
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72/28 is inconsistent with 'can't stomach another 2008.' Risk capacity may be adequate, but risk tolerance is the binding constraint and behavior is the larger threat to the plan.
Recommended structure:
- Reduce equity to roughly 50/50, not because of a market call but because a portfolio they will abandon in a decline is riskier than a lower-volatility one they will hold.
- Build a three-year spending reserve in cash, Treasuries, or a TIPS ladder so they are not forced to sell equities in a downturn. With $110,000 spending and $58,000 of Social Security at 70, the pre-Social-Security gap is the bridge: about $110,000 per year for six years, funded from the 401(k) and Roth.
- Withdrawal order: spend the 401(k) first in the low-bracket years before Social Security and RMDs begin, use the Roth to manage bracket edges, and consider partial Roth conversions in the 12% or 22% bracket. Do not drain the Roth early if it is needed later for tax-rate flexibility.
- Mortgage: 6.5% is a high guaranteed cost. Paying it off is equivalent to a risk-free 6.5% return, which is attractive, but it consumes liquidity. If they take the lump sum, pay off the mortgage from it; if they take the annuity, consider paying it down from the 401(k) over two tax years rather than in one.
- Guardrails: precommit to a rule, e.g., if the portfolio falls 10% from its high, cut discretionary spending by 10% until it recovers. A written rule is more useful than a risk-tolerance questionnaire.