Lump Sum or Annuity: Which Should You Choose at Retirement?

by Rande Spiegelman

Lump Sum Or Annuity: Which Should You Choose At Retirement? Splash image

Does your employer offer a traditional defined-benefit pension plan that guarantees you a monthly pension payment for life?

If so, congratulations are in order—such plans are becoming scarce these days. The trend toward 401(k)s, 403(b)s and other defined-contribution plans means that more and more workers must rely on their own savings and investments to supplement their retirement income.

However, with a defined-benefit plan, you’ll likely face a challenging choice at retirement: whether to take a qualified one-time lump-sum payout—which can be rolled over directly into a traditional IRA—or to receive a monthly annuity payment for the rest of your life or, in some cases, even longer.

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Rande Spiegelman is vice president of financial planning at the Schwab Center for Financial Research.


Discussion

Donald Moody from North Carolina posted about 1 year ago:

Since the lump sum distribution amount is based on some internal rate of return, does the current low interest rate market argue for taking the LSD now versus annuity payments which when annuitized in the future are likely to have a higher IRR interest rate factor?


Mark Wilson from California posted about 1 year ago:

I have this decision in the next 45 days and am thinking of rolling the lump sum into a deferred life income annuity but I have heard that since interest rates are low right now it is not a good time to choose either an immediate or deferred Annuity. I can't find an answer to sizing the benefits of waiting til interest rates rise ...which I think they will. Any rough order of magnitude way to calculate this?


J Morlock from New Jersey posted about 1 year ago:

I think this was a useful article that is worthy of a part 2.

It would be helpful if AAII could publish a spreadsheet to calculate the internal rare of return for an pension annuity offered by an employer so it can compared to taking a lump sum and investing it for income distribution over time. There should be a way to calculate the breakeven point - the number of years someone must live in order for the annuity payments to equal the value of lump sum invested for growth and retirement income distribution.

An annuity protects against longevity risk and eliminates the risk of having draw downs in an investment portfolio being depended upon to generate retirement income distributions. The major disadvantage of an annuity is lack of protection from inflation risk.

Potential retirees should understand that the present value of their pension is dependent on the interest rates used by their pension plan to calculate lump sums at the time they make an annuity versus lump sum election. The lump sum present value present of an annuity is maximized when interest rates are low. That's becasue a larger up front lump sum is required up to generate the annuity payments over a persons expected life. The lump sum present value of value of an annuity will decline as interest rates rise.


Rick Croote from Virginia posted about 1 year ago:

Omitted from consideration is the creditworthiness of the annuity provider. Just ask an AA pilot who is concerned about collecting less from the Gov't Pension Insurance Fund then what s/he otherwise might have received if AA had not gone bankrupt.


Jeff Kozimor from Oregon posted about 1 year ago:

Great discussion and article. J Morlock's notes are right on - well done!

The key is the longer that you may live, the better the pension annuity becomes. If you die earlier than the actuarial tables predict, you lose money. Taking the lump sum puts money in the bank and takes early death and company specific risk off the table (like American Airlines).

Another key consideration is covering essential expenses with "guaranteed" income such as a pension and social security. That means that if all hell breaks loose in financial markets (like the period we just experienced), a retiree has peace of mind that they can cover their essential expense to live. A pension for the most part, takes market risk off the table.

Mark Wilson above, leads to another strategy; given that interest rates are presently low thus providing a larger lump sum amount today, why not take the lump sum now and wait for interest rates to rise and then purchase an annuity from a low cost provider?


Robert Mann from Michigan posted about 1 year ago:

On what life expectancy is the lump sump calculated: employee life expectancy, combined employee-spouse life expectancy, other? Could taking a lump-sum now purchase an annuity providing greater monthly payments than a 65% survivor pension from the employer?


Jeff Kozimor from Oregon posted about 1 year ago:

Caveat: I am not an actuary, and for exact answers it would be best to ask the plan administrator.

Given that, most should be based on the employees age at retirement, interest rates, and life expectancy. All other options, such as a 65% survivor pension benefit or others are mathematically equivalent to the single life option. If you want a little more in one place, you give up some $$$ from the single option.

It is unknown what you can get from another annuity sponsor and you'll have to shop it. If you do, let us know! In most cases, annuity firms need to make money, especially insurance companies. It seems logical that the employer sponsor pension annuity is not out to make a lot of money charging their retires high admin fees.


Donald Burman from Illinois posted about 1 year ago:

A site I've run across with useful limp sum calculators is: http://www.pensionbenefits.com/calculators/

Nice thread, thanks.


Dave Gilmer from Washington posted about 1 year ago:

J,
The way I calculate the IRR is with a $30 HP financial calculator, using the cash flow / IRR function, making the only reasonable assumption that you can make about your life span, and that is that you will live an "average" life, which I think right now is somewhere around 85. You can of course use any number of years for the cash flow you want, however I think this will bias your results - remember you could get hit by a bus tomorrow, so I think to assume you are better than average is to play right into the insurance companies "longevity table."

I just made this decision for myself about 9 months ago and I spent about 6 months doing my research, what it came down to for me was an analysis of my needs vs my other cash flows and IRA / Roth accounts.

The NEEDS of the retiree was not stressed much at all in this analysis and I think is the most important aspect of it. What I mean by this is everyone has income in retirement that can be broken down into areas such as NEEDS, WANTS, & LIKES. I believe it is not necessary to fund 100% of all of the above with a secure fixed income. In other words if you also have a fair sized 401k account, you probably only need to fund the NEEDS portion of your income with fixed income such as pension and SS. The rest you can fund by taking a little more risk with your 401k type money.

So most importantly decide how much fixed income you really need (considering of course that most of it may not be inflation adjusted - including SS in the future) and then work your calculations from there.

It is entirely possible that the best choice is to take the lump sum but convert say half of it to an immediate annuity (and maybe even over 2-3 years 1/3 at a time) and put the rest into a good growth index fund that will at least track the market. What I did was a variation of this, part lump sum on what was a supplemental voluntary pension, but the main income from the annuity with survivor benefits.

fd


Dave Gilmer from Washington posted about 1 year ago:

As mentioned this subject probably needs a part 2.

Generally I liked the article, as I think it gave fair coverage to both Risk, and Cost comparisons of managing the lump sum yourself.

However, I disagree with the author's general rule that annuities are more attractive for those that expect to live longer. NONE of us really know whether tomorrow will be our last day or 30 years from now. The correct question to ask is for the NEEDS portion of my income do I need more fixed income.

I also don't think it is ever appropriate to annuitize 100% of your retirement savings to cover your income needs as this is just a disaster waiting to happen.


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