How to use the Pension Option Analyzer

A common problem that retirees face is choosing between the options offered in a workplace pension. These options often include a lump-sum payout and one or more lifetime pension options. The pension options usually differ in terms of survivor payout.

You can easily compare the effect of these different options within an Income Lab plan by producing two or three plans that differ only in which of the options is included. But sometimes it helps to look at the pension options themselves and understand their value. This can be difficult because comparing a lump sum to a lifetime pension is like comparing apples and oranges. Penny's Pension Option Analyzer tool can help here.

You will find this tool in the Retirement planning focus.

Inputs

The tool will automatically pull in client ages. From there, simply select the pensioner (i.e., whose life the pension is keyed to), whether the analysis should include the spouse (as a surviving beneficiary of the pension), and the plan type (private, public, etc.).

Next, enter the payout options for the pension. Often there will be at least two - a lump sum and a monthly pension - but here may be several different pension options with different spousal survivor benefit levels. For example, a 100% survivor benefit might pay $3,000/month while a 50% survivor benefit pays more - say, $3,200 - but of course then pays less once the pensioner dies. You can also enter any cost of living adjustments in this section.

The tool lets you compare any two options by selecting the option using the colored circles to the left of the options in the “Compare” column.

Finally, you'll want to set an expected/average assumed rate of return and longevity assumptions. You can set whatever rate you want, but the field will default to the plan's nominal expected rate. (This rate will be used in net present value calculations and in IRR comparisons in the outputs.) Similarly, the longevity assumptions will default to whatever is in the Income Lab plan, if there is one.

Outputs

The tool displays a heatmap showing the net present value of benefits in a variety of longevity scenarios, coloring the cells that favor a pension or lump sum option in the same color as you see in the inputs.

You can click on a cell in the heatmap to see details on that longevity scenario.

If you are comparing a lump sum to a pension option, you can also view the heatmap in terms of internal rate of return (IRR) by choosing this option in the upper right of the heatmap area. IRR is useful when comparing a lump sum today with a stream of future pension payments because it expresses the pension’s value as an implied annual return on the lump sum you give up. When comparing one pension option with another, however, there is no single upfront investment or lump sum to serve as the starting value. Instead, you are comparing two different streams of future payments. Because that comparison does not produce a meaningful, unique “rate of return,” IRR is not shown in this case. NPV is the more appropriate measure, because it discounts each payment stream to today’s dollars and allows the two pension options to be compared directly.

Above the heatmap is a set of output cards. These show values for the chosen rate of return and longevity in the inputs. 

Possible outputs include:

1. IRR: Internal rate of return. The rate by which the lump sum converts to the pension income stream
2. Break-even year: How long the pensioner would have to live for the two options to be equivalent in value (with the surviving spouse's longevity held constant at the assumed longevity age)
3. Moneys-worth ratio: The ratio of the value (NPV) of one option to the other
4. NPV: Net present value of future cash flows, discounted at the assumed rate of return
5. Implied payout yield: The annual pension amount divided by the lump sum option

If you would like to explore different longevity assumptions or rates of return, you can explore different settings here in the “Key Variables” section.

Other Outputs

At the bottom of the tool, you will find further detailed analysis in tables as well as any important information about the pension, depending on the pension type (public, private, etc.). This important information may include notices or warnings that are relevant for compliance or to be sure you are aware of in discussing the pension options with the client or the client's other tax or legal advisors.