The Million Dollar Question: Pension Lump-Sum Or An Annuity?

If you are fortunate enough to have a defined benefit plan at work, you may have a very important upcoming decision to make.  The task of deciding between a lifetime monthly payment or a seven figure one-time payment can be daunting. To compound the complexities, there are various different annuity options factoring in spousal payments and fixed term guaranteed payments.

Before stressing over the details, the first step is to understand the advantages and disadvantages of each option.   The table below objectively compares the two:

Annuity payments Lump-sum payments
Your monthly income is fixed, you have no investment decisions, and your tax planning is straightforward You’ll face tax issues in deciding how to take the lump sum, and you’ll have to make investment and estate planning decisions
You generally can’t transfer your money to another investment or postpone or accelerate payments if your health or financial situation changes You control how your money is invested and how fast you spend it.  You can roll the money over to a tax-deferred retirement account and have access to the money if needed for an emergency or an investment opportunity.
Most annuities pay a fixed monthly amount.  At an inflation rate of 3.5% a year, a fixed income annuity would lose half of its purchasing power in 20 years Your investments may earn higher returns than an annuity would offer and help you better keep pace with inflation
Your benefits don’t depend on your investment results, so declining interest rates or falling stock prices won’t reduce your income If your investment perform poorly, you could end up with less money than if you’d taken a fixed monthly payment
You can’t outlive your money (although after inflation it may not meet all your needs) You may outlive your money if you live long enough or you don’t make good investment or spending decisions
You must pay income taxes on your monthly distribution If you roll over your lump sum to another tax-deferred plan (IRA), you’ll generally be taxed only as you withdraw the money.  But, if you don’t roll over the lump sum, it’s taxable as income in the year you receive it.
Once you (and your beneficiary, if you choose a survivor option) die, all benefits cease and there is nothing for your heirs The unspent portion of your lump sum can be left to your heirs when you die

After understanding the basic concepts, the best way to look at the “Million Dollar Question” is to view the pension in terms of your overall portfolio.

  • Have you saved in a 401(k)?
  • Does your spouse work as well?
  • Does he/she have a pension?
  • How good is your current health?
  • How much control of your money do you want?
  • Is the pension adjusted for inflation?
  • Are you eligible for Social Security?

Each of these questions will allow you to lean towards the best retirement choice for you.  In summary, the age old wisdom of, “If you don’t know, ask!” perfectly applies to retirement questions.  A financial planner can help sort through the noise and help you find the optimal solution.

About the author

Anthony Farella, CFP®

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