Pension Election and Sequence Risk at Retirement
Tom, 63, is retiring in three months. He has USD 900,000 in a 401(k), a USD 300,000 pension lump sum option, or a lifetime annuity of USD 18,000 per year with a 100% survivor benefit for his wife, 61. Social Security at 67 will be USD 34,000 per year combined. Their after-tax spending target is USD 70,000. They have USD 60,000 cash and a mortgage-free home worth USD 500,000. Tom's 401(k) is 80% equities and 20% bonds; he plans to keep that allocation because 'retirement is 30 years.' A 20% market decline in year one would reduce the portfolio to USD 720,000 before withdrawals. They want to know whether to take the lump sum, the annuity, or a mix, and how to fund the first five years of spending.
1. Evaluate the pension options and recommend an approach.
Read the worked answer
The annuity pays USD 18,000 on a USD 300,000 lump sum, a 6% payout rate, with a 100% survivor benefit. For a couple age 63 and 61, that is attractive relative to a safe withdrawal rate from a diversified portfolio, especially because it transfers longevity and survivor risk to the insurer. The weakness is that the payment is fixed, so inflation erodes it over a 25- to 30-year retirement. The lump sum offers liquidity and inflation-growth potential but shifts longevity and investment risk to Tom and his wife.
The decision should be based on how much guaranteed income they need. After Social Security at 67, they will have USD 34,000 guaranteed. Adding the annuity gives USD 52,000 of lifetime income, leaving about USD 18,000 after tax to come from the portfolio. That is a low burden on USD 900,000. If they take the lump sum, the portfolio is larger but they must fund the full spending gap and bear market risk. A reasonable approach is to take the annuity for the essential spending floor, keep the 401(k) invested for growth and inflation, and use the USD 60,000 cash plus a short bond ladder for the first two years. If health is impaired or they need liquidity for long-term care, the lump sum deserves more weight.
2. Analyze the sequence-of-returns risk and design a five-year funding plan.
Read the worked answer
An 80/20 portfolio is too aggressive for someone beginning withdrawals, not because retirement is short, but because withdrawals during an early decline permanently reduce the portfolio. If the 401(k) falls 20% to USD 720,000 and they withdraw USD 70,000, the portfolio is USD 650,000 before any recovery. A recovery then requires a much larger gain to get back to the starting point, while withdrawals continue.
A five-year funding plan should separate spending from the growth portfolio. Hold one to two years of net spending in cash, about USD 70,000 to USD 140,000, and another three years in high-quality short- and intermediate-term bonds, about USD 210,000. Fund the first five years from these reserves and maturing bonds, not from equities in a down market. That gives the equity portion time to recover. Reduce the overall equity allocation to about 50% to 60%, with 35% to 40% bonds and 5% to 10% cash. Use a guardrail: if the portfolio falls more than 10% in a year, cut discretionary spending before selling equities. Delay Social Security to 67 or later if health supports it, because the higher guaranteed benefit reduces portfolio withdrawals for life.
3. Recommend a target allocation and rebalancing policy for the decumulation phase.
Read the worked answer
A suitable target is 50% to 60% globally diversified equities, 35% to 40% high-quality bonds, and 5% to 10% cash. The annuity, if chosen, provides the guaranteed floor, so the portfolio can take moderate growth risk without threatening essential spending. The equity portion should be diversified across regions and sectors, not concentrated in the former employer or a single fund. Bonds should be laddered to match the first several years of withdrawals.
Rebalancing should be rules-based. Review annually and when any asset class drifts more than five percentage points from target. In decumulation, rebalance with withdrawals and dividends rather than by selling appreciated assets unnecessarily. If equities rise sharply, harvest gains to refill the cash and bond buckets; if equities fall, spend from bonds and cash. Document the policy so that a market decline does not trigger an ad hoc decision. The plan should also specify a spending review if the portfolio falls below a pre-set threshold, and a review of the annuity decision with the couple's health, tax, and estate advisers before the election deadline.