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When faced with the decision of taking a lump sum pension payout or receiving monthly annuity payments, your course of action will depend on your individual circumstances. Key factors include your life expectancy, others sources of income and how soon you will be paid the lump sum.
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Generally speaking, living longer makes the annuity a better choice, but if you’re given the opportunity to receive the lump sum early, that option could be more attractive. Expectations for inflation and investment returns can also influence this decision.
The lump sum option, while typically riskier, also offers more potential upside depending on your skill as an investment manager and the performance of the market. However, those who are risk-averse or don’t feel confident investing the lump sum may opt for the reliability of guaranteed annuity payments.
Pension plans offered by employers pay you a guaranteed monthly stipend from the time you retire for as long as you live. These payments are guaranteed by the employer, as well as by the Pension Benefit Guarantee Corporation (PBGC). Many plans provide spousal benefits that will continue payments to a partner in the event of the pension holder’s death. Some also offer inflation protection in the form of payments that are adjusted to reflect the cost of living.
But employers frequently give covered employees the option to receive a lump sum instead of steady smaller monthly payments for life. Someone who opts to receive the lump sum will receive no further payments from the pension. Instead, it is up to the employee to invest or manage the lump sum themselves.
If the investment performance is good, this can result in a larger overall financial benefit compared to the annuity option. If the lump sum recipient makes poor investment decisions or the market performs badly, the lump sum option could turn out to be less advantageous.
Generally speaking, a lump sum can be a good option for someone who’s in poor health and does not have a long life expectancy. It may also make sense for someone who has no spouse or has other income that can be used to pay retirement expenses. Plans that do not have features such as spousal payments and inflation protection can also reduce the value of the annuity option.
However, when the lump sum will be paid is a key consideration. Some companies will pay a lump sum years before the usual retirement age. If this happens, the lump sum can be invested sooner and have more time to benefit from compound interest. In the end, this option could result in more money than the sum of all annuity payments.
There are a number of caveats associated with this choice, though. These include taxes, which may be due immediately on a lump sum unless it’s rolled over into traditional IRA within 60 days of distribution. Investment fees also have to be taken into account, as these can affect the performance of an investment portfolio funded by a lump sum.
If you need help help assessing your choices and deciding between a lump sum or annuity, consider talking it over with a financial advisor.
Imagine that you are deciding whether to take a $78,000 lump sum or receive $650 monthly annuity payments. Your current age and life expectancy are key considerations in this decision. For example, assume you are 60 now, expect to live until 80 and will start receiving your benefits when you retire at age 65. That means you’ll receive 180 payments of $650 for a total value of $117,000. If you live until 90, the cumulative value of the annuity payments bumps up to $195,000.
If the plan includes a spousal benefit, as well as inflation protection, it can be worth much more. For instance, with a 2.5% annual inflation adjustment and 100% spousal benefit for a 55-year-old spouse who will live to 85, the annuity payments would total over $266,000.
Now, say you take the $78,000 lump sum. You can receive the money at age 60 and put it into investments. If you live to age 80, your investments would only need to grow at 3.39% per year to equal the $117,000 value of the annuity with no spousal benefits or inflation adjustments. In order to match the value of the more feature-laden annuity with inflation adjustment and spousal benefits, your investments would have to earn 7.56% each year.
Keep in mind the fact that the decision to take a lump sum is hard to undo. Once it’s paid out, the employer has no further financial obligation. It’s possible to later use the money received from a lump sum to purchase an annuity, but the associated fees mean this move will likely result in a smaller monthly payout than the original annuity benefits.
Remember, a financial advisor who offers retirement planning services can be a valuable resource as you make decisions surrounding annuities and other sources of retirement income.
When deciding between a lump sum or pension annuity, consider your current age, expected lifespan and when you will receive the lump sum. If you expect to live longer, it can mean the annuity is more valuable. The sooner you receive the lump sum, the more valuable that option may be.
Bear in mind that accepting a lump sum payment means the company has no further financial obligation to you and you’ll be responsible for investing the money to generate an adequate return. If you stick with the annuity option, on the other hand, the company bears the burden of ensuring that you’ll receive monthly payments for life.
A financial advisor can potentially help you manage your annuities and other streams of income in retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Whenever you are doing long-term financial projections, inflation is an important consideration. SmartAsset’s inflation calculator can help you see how the buying power of a dollar changes over time due to inflation.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Dena Holloway is a writer, editor, and content creator based in the United States. She has written for a variety of publications, including Men With Wings Press, where she covers arts, automotive, travel, and fashion. She's also a certified yoga instructor and works as a freelance copywriter.
