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How To Compare Pension Options: Lump Sum Or Annuity?

Pros And Cons Of Lump Sum Or Annuity Pension Choices


Lump Sum or Annuity?

Carefully compare pension options before taking a lump sum.

Chris Stein/Digital Vision/Getty Images

Some companies require you to take your pension plan in the form of an annuity payout; essentially monthly payments for your life. More and more companies, however, are giving you the option of taking your pension as a lump sum distribution instead of an annuity payout. You need to carefully weigh out the pros and cons of a lump sum or annuity distribution before making this decision.

Pros and Cons of Lump Sum Pension or Annuity Distributions

Pros of Lump Sum Pension Distribution
  • Access to money to do with as you please.
  • If properly managed you may be able to generate the same amount of income that the annuity would provide and retain control of the principal to pass along to heirs.
Cons of Lump Sum Pension Distribution
  • Having access to a lump sum of money makes it easy to spend it all.
  • If money is improperly managed or invested poorly it can disappear quickly.
Pros of Annuity Pension Distribution
  • Guaranteed income for life.
  • No investment management decisions or responsibilities.
Cons of Annuity Pension Distribution
  • Your future pension benefit guarantee is based on the financial stability of your former employer. Benefits could be significantly reduced if they do not properly manage their pension fund.
  • Fixed monthly amount will not keep pace with inflation.(Some pension benefits have a cost of living adjustment build in, but most do not.)

Once you understand the pros and cons, you need to look at the potential rates of return of each choice and compare that with the risks involved.

Below is an example. Numbers are from a real retiree who was trying to decide if he should take a lump sum or annuity distribution. (You can also check out my personal take on the decision in What Would I Do?).

Real Life Example: Retiree Must Decide To Take Either A Lump Sum Or Annuity Pension Distribution

Retiree named Joe: Age 62 with 30 years of service

  • Single Life: $2,250
  • 50% Joint and Survivor: $2,078
  • 100% Joint and Survivor: $1,931
  • Life with 10 years certain: $2,182
  • Lump Sump: $347,767


Explanation of Pension Annuity Choices

If Joe chooses the single life option he will receive $2,250 for as long as he lives. The monthly benefit stops when he dies, so if he lives only one year, no additional funds will be paid out. If he is married, his spouse will not receive a survivor benefit.

If Joe chooses the 50% Joint and Survivor option, he will receive $2,078 per month, and upon his death, his spouse would receive $1,039 per month as long as she lives.

If Joe chooses the 100% Joint and Survivor option, he and his spouse will receive $1,931 per month for as long as either of them is still alive. In this scenario, Joe is taking $319 less a month so his spouse will continue to have a substantial benefit upon his death. Think of that $319/month as buying life insurance.

How Do These Pension Annuity Choices Compare To Taking A Lump Sum Distribution?

To answer this, Joe must calculate the internal rate of return of the annuity and compare that to the expected internal rate of return on the investments he would make if took the lump sum distribution.

Calculating the Internal Rate Of Return Of The Pension Annuity Choices

To calculate the internal rate of return of the single life annuity pension choice, Joe would use a present value of $347,767, monthly payments of $2,250 every month for his life expectancy of twenty years, and nothing left over at the end. This equates to a 4.76% internal rate of return. (See the online calculator in Internal Rate Of Return for additional details on these calculations.)

This rate of return is assuming the pension is well managed and continues its payments to retirees as scheduled.

Calculating the Internal Rate Of Return Of The Lump Sum Distribution Choice

If Joe takes a lump sum distribution, he will receive $347,767. He can then choose to invest these funds however he wishes. If he follows the investments rules in Strategies For Creating Retirement Income From A Portfolio, he may be able to create an income stream of 5% a year, have the ability to increase this income each year to help offset the effects of inflation, and retain control of his principal; however, he would need to follow a disciplined investment strategy over a long period of time to accomplish this, and - of course - there are no guarantees that it would absolutely work. If it does work, here is the income Joe might expect:

$347,767 x .05 (5%) = $17,388 / year initially, or $1,449 per month, with an expected increase each year to help offset the effects of inflation. (By the time Joe reaches 82, if the investments are able to support a 2% increase a year, his distributions would increase to $2,239 per month.)

Using a present value of $347,767, monthly payments of $1,449 that increase each year by 2% a year and Joe’s single life expectancy of about 20 years, and a future value of $347,767, this would equate to an internal rate of return of about 6.5%. This rate of return is assuming the funds are managed appropriately, thus providing the inflation adjusted distributions while maintaining principal.

Comparing Pension Annuity To Lump Sum Distribution

The question Joe now needs to ask is, “Is the additional potential return worth Joe taking on the risk of managing the assets himself?” Some people absolutely do not feel comfortable with the funds remaining in the company’s pension plan. Others absolutely do not feel comfortable rolling the funds out of the plan and managing it themselves, or hiring someone to manage it.

You must evaluate the pros and cons, and the equivalent rates of return, and make your own decision.

Dana Anspach, CFP®, is one of only a handful of people to hold the Retirement Management Analyst designation. She has been About.com's MoneyOver55 Expert since 2008 and is the founder of Sensible Money, LLC. You can learn more about Dana's work in her bio.

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