The former General Motors white-collar employees have been given a choice between a lump sum payout of their retirement account or a guaranteed monthly annuity check for the rest of their lives.
According to recent published accounts, there is much agonizing over which lever to pull. Anxiety caused by analysis-paralysis is being replayed across all of big-company America as the baby boomer bubble moves into retirement. Corporations see this as a way to rid themselves of the loose cannons on their decks -- their underfunded pension plans.
A typical monthly payment is about $5,000 and the lump sum alternative option would be about $800,000. Unfortunately, those who elect the monthly check will no longer have GM and the U.S. Pension Benefit Guaranty Corp. backing them up. Why not? Because someone talked GM into having Prudential Life Insurance sell the annuity to those who choose the monthly check for life. Prudential is described as being "strong" by a representative, but what does that mean? Not that long ago, Mutual Benefit went out of business when it was the 14th largest life insurance company in the country.
Those opting for the monthly check realize that the capital (the $800,000) will be gone forever when they and their spouses have died.
Nothing will be there for children or grandchildren. Moreover, there is no protection from inflation. That monthly $5,000 will be the equivalent of $2,000 in 20 years with 4 percent inflation.
So, what's the alternative? A simple mix of bonds and dividend-paying stocks will yield between 4 and 5 percent just in interest and dividends alone -- without touching a drop of the principal. The half of the principal left in stocks can be expected to rise with inflation over the remaining life of the retiree, and this offers the necessary protection from inflation. Plus, the retiree retains control of the capital, which can be spent incrementally as it rises in value.
That 4 to 5 percent return from interest and dividends will generate between $2,600 and $3,300 per month, which is less than the $5,000, True.
But all these retiring folks have other income from Social Security and possibly even jobs. What looks like an enticing additional $2,000 of the annuity payment would have been taxed at the highest marginal rate of over 30 percent, including state income taxes. After tax, the advantage of signing up for the annuity is only about $1,400 more than just income from interest and dividends. For an extra $1,400 of after-tax money -- a marginal increase that will drop to nothing with a modicum of inflation -- GM people are signing away their $800,000 benefit in this example.
What could possibly be worse? The standard of comparison would be something like a 50/50 mix of stocks and bonds that have averaged a return over the past 10 to 12 years of around 6.5 percent. This so-called "lost decade" has included two major crashes. During the past 40 years -- which included years of hyperinflation -- the same mix earned an annual average of around 11 percent.
But there's another alternative. This would be the variable annuity offered by Vanguard or Fidelity that guarantees 5 percent per year based on what you deposit, but you don't give up the money. You can walk away at any time with whatever your balance happens to be worth. If the balance goes up, that establishes a new base upon which the 5 percent return is paid. If the balance goes down, however, they always pay the 5 percent on highest-attained balance.
If, in some unlikely doomsday situation, the underlying bonds and stocks dropped to zero as a result of stocks plunging and your 5 percent annual income draw, Vanguard guarantees that they will pay the 5 percent for the rest of your life. Given the 40-year results of a 50/50 mix cited above, (the 11 percent annual return) or the 12 year results that included two market crashes (6.5 percent return), paying 5 percent is a reasonable bet for Vanguard and its customers.
So, why aren't GM employees wrestling with an alternative this attractive with totally diversified underlying investments? Because they are getting self-serving advice from an insurance company that plans to make a lot of profit on all that money, buying a "guaranteed" income stream -- income that is perversely guaranteed to fall with the rate of inflation. Moreover, that guarantee is only as good as Prudential's ability to remain solvent, and we need no further lessons on what surprises can happen at big financial organizations. No thanks.