One of the questions we often get from our clients is, “Should we take the lump-sum option or the annual payments when receiving distributions from our company pension plan?”
Just like deciding whether to “buy or rent”, there are several factors in play in determining the best course of action. Let’s first go over these two retirement plan payout options:
Lump-sum – This gives the retiree the benefit of a fully vested cash balance in one lump-sum. If the money is invested wisely and continues to grow, often being rolled over into an Individual Retirement Account (IRA), it can give retirees even more money for retirement than initially envisioned.
Annuity – The retiree gets regularly scheduled payments from the pension that are distributed for a lifetime. With a joint annuity, this guarantee extends to the life of a designated beneficiary, such as a spouse. These payments are calculated by an actuary and contracted for regularly scheduled disbursements by an insurance company.
A significant part of deciding whether to take a lump-sum or annuity can come down to your overall expectations while factoring in your income needs, aversion to risk, and time horizon.
Let’s begin with the annuity. While the idea of getting a consistent payment for the rest of a lifetime sounds good, is it really the best option?
The main advantage of annuities is the retiree, and their spouse/beneficiary if it is a joint annuity, know they will not run out of money during their lifetime with scheduled payments. This can be a security blanket for people who are used to receiving a paycheck from work, as a payment regularly shows up in their accounts.
These payments, however, will not get a Cost-Of-Living-Adjustment (COLA) and the funds will not grow if inflation rises. As we have seen before, such as the inflation surge post-pandemic, not having a COLA can really impact purchasing power and lifestyle. Also, the more the spouse or beneficiary receives with the survivorship option, the less in monthly payments it will be.
There are also no real guarantees with private pension plans if they are not covered by PBGC (Pension Benefit Guaranty Corporation), a federal agency that insures in case of insufficient funds to pay the benefits. In that event, you are betting your company is going to be viable and the pension plans solvent way into the future. Even if the PBGC protects the annuity, there is no guarantee that there will be 100% of the funds that were promised by the company. And if you ever just want to cancel the annuity contract because of a financial emergency or life-altering event, be aware of penalties and surrender fees. 1
If you are comfortable with investing or having a financial advisor manage the funds, for many the lump-sum option may be preferable. There is also the option of rolling over the funds into a traditional IRA, which will enable the money to grow tax-free until withdrawals are taken or Required Minimum Distributions (RMDs) occur by age 72 at the time this was written. The rollover also gives a greater selection of investment options from stocks, bonds, ETFs, mutual funds, etc. to potentially increase the annual rate of return and keep up with COLA. While annuity contracts will also expire with either the death of the pension plan employee or if a joint annuity the specified beneficiary such as the spouse, the lump-sum funds or assets in an IRA do not have an expiration date and can be passed on to other family members. 2
The main caveat with a lump sum option is the risk of running out of money due to losses sustained in investments or depleting the fund balance for other reasons. Unlike a regularly scheduled annuity payment, consistent access to funds may not always be there if the investment goes south. As always with any investment, “past performance is no guarantee of future results.”
For a further comparison on whether to take a lump-sum or an annuity, here are some charts that illustrate the difference between converting a lump sum into an IRA vs. the annuity payments over a 30-year span from age 65 to 95. For this example, we are assuming a lump-sum value of $750,000 or an annualized payment of $35,000, represented by the brown area. The spending needs, the dotted lines, are $75,000 a year with a 3.5% inflation rate. Finally, the IRA assets, represented by the blue area, are getting a modest 5% return* without taking any distributions until the required RMDs at 72.
As you can see, the annuity payments stay flat with the increasing spending costs, which get higher year-by-year due to inflation. Using the same 30-year period where the pension is rolled into an IRA and assuming that modest 5% rate of return represented, the funds are more likely to keep pace with inflation and the spending needs.
Another way of looking at this is to see the cumulative lifetime value of benefits from either strategy, which this other chart shows. The time range is still over the same 30-year period from age 65 to 95, where the green area represents the $750,000 pension being rolled over into an IRA at a 5% rate of return with distributions starting at 72 and the orange area represents taking the annuity payments at $35,000 a year.
Analyzing this span of 30 years from 65 to 95, the chart shows that the cumulative lifetime benefits will be just over $1 million for the annuity while for the pension rolled over into the IRA it would rise to almost $3 million, given the 5% rate of return. Assuming there are continued returns on the investment portfolio, this would help keep pace with inflation and give a greater cumulative total. This would be a big advantage to the lump-sum payment, as annuity payments do not have a COLA.
Though there are many factors in the decision to take a lump-sum or an annuity, it will ultimately come down to choosing a payment plan that aligns with your unique needs, time horizon and risk tolerance. You may want to check with a financial advisor to run through the numbers and determine the best course of action for your own personal situation.
*Rates of return used in the article are strictly hypothetical and should not be construed as an advertised rate of return, a reflection of past or future expected performance, or guarantees.
CITATIONS.
1 – https://money.cnn.com/retirement/guide/pensions_pensions.moneymag/index10.htm?iid=EL
2 – https://www.kiplinger.com/retirement/604641/why-a-pension-lump-sum-option-is-better-than-an-annuity-payment
This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
