Financial decision making

Adam Grossman writes about making financial decisions. How valuable is extensive analysis?

Here are two of his important decision suggestions.

Pension choices. These days, only a minority of workers have a traditional pension. For those who do, though, this benefit requires a long list of decisions. The first question is the most fundamental: Employees can claim their benefit as a single lump sum or in the form of guaranteed monthly payments for life.

Those who accept the lump sum can roll it over into another retirement account and manage it the way they do the rest of their portfolio. But for those who opt for the monthly payments, there are several additional options to consider.

Workers who are married can choose a survivor benefit—typically 50%, 75% or 100% of the worker’s own benefit. Those who worry their spouse might predecease them can choose a “pop-up” benefit, which increases the workers’ own payments if their spouse dies early. And for those who worry about their own longevity, some pensions offer benefits that are guaranteed for a period of years.

If this all seems complicated, it is. Because the choice is irrevocable, it tends to induce stress. But here’s what’s surprising: If you run the numbers, the differences often aren’t as significant as they might seem. To understand why, let’s look at the math used to evaluate complicated choices like this.

Present value analysis allows us to compare the value of a dollar today with the value of a dollar received at some point in the future. Intuitively, it makes sense that a dollar you receive today would be worth more than a dollar next month or next year. And a dollar received further in the future—say, in 10 years—would be worth even less than that. Using a “discount rate” of 7%, which is what you might earn by investing a sum of money today, the value of a dollar today falls to just $0.51 after 10 years and to just $0.26 after 20 years.

This is relevant to pension analysis because it reveals the diminishing value of payments received far in the future. Let’s look at a simplified example. Suppose a pension offers these two options:

• $3,000 a month for life with no survivor benefit
• $2,700 a month for life with a survivor benefit of 50%

The difference between these two options—$300 per month or $3,600 per year—might seem significant today. But because of the present value dynamic described above, it isn’t nearly as significant as it might seem. Using that same 7% discount rate, that $300 difference would shrink to just $152 in 10 years and $77 in 20 years. The survivor benefit would potentially extend the number of years of payments, albeit at a lower rate.

The bottom line: You should never give financial decisions short shrift. But as these numbers reveal, it may not be worth belaboring the decision. Whichever option you choose, the pension benefit is going to be worth far less in the distant future—and having a plan to cope with that shortfall is where you should probably focus your energies.

Social Security. Retirees can claim their benefit at any time between ages 62 and 70. For each year the retiree waits, the monthly benefit increases. But each year a retiree waits is also a year with no benefit at all. As a result, retirees need to guess how long they’ll live, and that’s never easy. Is there another way to make this decision?

If you’re unmarried and in generally good health, the decision is straightforward: Most everyone—myself included—recommends waiting until age 70 for the largest possible benefit. But if you’re married, should you both wait until 70? At first glance, that might seem like the logical choice—and that’s what the math says. But sometimes the differences are insignificant.

When most people run the numbers, what they find is that there’s only a modest difference for the lower-earning spouse if he or she claims a bit earlier—say, at 68 or 69 instead of 70. Why? For starters, none of us knows how long we’ll live, so claiming earlier always has an inherent advantage. And because of the present value effect, the true value of forgoing benefits today for a larger check later may be smaller than it appears.

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