If you're lucky enough to work for a company that offers a pension, you may be confronted with an important decision upon retirement.
Should I take that pension in the form of a lump sum, or should I take the pension in the form of a monthly annuity?
Which is better for you depends on a variety of factors. These are factors to carefully consider because you don’t get a redo.
At Advance Capital Management, we’ve helped many people navigate major pension plans, including AT&T and the Federal Employees Retirement System. So, we know how much of a difference a pension can make in achieving a comfortable retirement.
To help you make the choice between a lump sum or annuity pension, I cover the most important factors to consider, including the pros and cons of both options. By the end of this article, I hope you’ll have a better understanding of which pension option makes the most sense for you.
This article covers the following:
Monthly annuity pension
Annuity pros and cons
Lump sum pension
Lump sum pros and cons
Deciding what’s better for you
How an adviser can help
Option 1: Monthly annuity pension
Let’s actually start with the monthly annuity and what that is.
A monthly annuity pension provides a fixed, regular income to you during your retirement years. This is generally on a monthly basis.
The size of your annuity payment depends on things like your years of service, salary, retirement age and any survivor benefits.
Monthly annuity pros and cons
Why would you want to choose the pension annuity? Well, there are a couple of big benefits of a monthly annuity.
Income for life. Perhaps, the most significant benefit of a pension annuity is that it provides a guaranteed income stream for the rest of your life (if you choose a single-life annuity) or the lives of both you and your spouse (if allowed to choose a joint-life annuity). This fixed income can help cover essential living expenses during retirement, regardless of how long you live. So, if your monthly pension amount is $2,500, you’re going to get $2,500 a month for the rest of your life.
No investment risk. Unlike other retirement income sources that are subject to market fluctuations, pension annuities offer protection against investment risks. Regardless of how the financial markets perform, the annuity payout remains consistent as per the terms of the contract.
Overall, the predictability and stability of monthly pension payments can make budgeting and financial planning more manageable during retirement. You know exactly how much you'll receive each month, allowing you to plan your expenses accordingly.
Now, what are the drawbacks?
Survivorship limitations. Typically, you can only name your spouse as the beneficiary of your monthly annuity. Also, there are often limitations on what amount your spouse will get upon your death. It’s common for spouses to receive about a 50% survivor annuity. However, there are some plans that do offer 100% survivor annuity; it can vary from plan to plan.
No inflation protection. Most corporate plans don't have what they call cost-of-living adjustments built in. That means the value of your monthly annuity can decrease over time. For example, let’s say inflation is 3%. In 20 years, a $2,500 monthly annuity would lose about half of its spending value. You would then need more like $5,000 a month to have the equivalent of $2,500 a month today.
While a monthly annuity pension can be suitable for some retirees seeking guaranteed income, others may dislike the limited flexibility and may find the lump sum option more suitable for their circumstances.
Option 2: Lump sum pension
Now, let’s break down the pension lump sum option.
By electing the lump sum, you receive your entire pension as a single, one-time payment, rather than as a series of periodic payments (like the annuity).
The lump sum amount is computed by determining the present value of your future monthly guaranteed pension income. It’s essentially based on three variables: your monthly pension amount, the rate of interest your company uses to calculate the lump sum, and your life expectancy.
Lump sum pros and cons
What makes the pension lump sum a good option? The benefits involve greater flexibility and control.
Investment opportunities. With a lump sum pension, you have the flexibility to invest the money in an IRA account according to your preferences and risk tolerance. You can allocate the funds across different assets, such as stocks, bonds, or mutual funds, to potentially grow your wealth.
Greater flexibility and control. A lump sum payout provides you with maximum flexibility and control over your funds. Rather than receiving periodic payments, you can manage the frequency and amount you withdraw as you see fit, allowing for more personalized financial planning.
More beneficiary options. With the lump sum, you can name one or more beneficiaries. You can name your spouse as a beneficiary, but you can also name your kids or even charitable organizations. So upon your death, that money left over will go to whoever you have named as the beneficiaries.
So, what are the drawbacks of a lump sum pension?
Investment risk. With a lump sum, you assume the responsibility of managing and investing the money to generate income throughout your retirement. Depending on investment decisions and market performance, there is a risk of potential losses or reduced returns, especially in volatile or bearish market conditions.
Overspending/longevity risk. While a lump sum can offer flexibility, it also poses the risk of overspending or outliving your retirement savings. You must carefully manage withdrawals to ensure that the money lasts throughout your lifetime. Therefore, if you consider yourself fiscally irresponsible, it may make sense to take a monthly annuity.
Given these drawbacks, it’s crucial for you to weigh the pros and cons of a lump sum pension payout and carefully assess your financial situation, risk tolerance and retirement goals.
Deciding what’s better for you
So, which pension option is better? It’s ultimately a personal decision.
As I’ve discussed in this article, choosing between a lump sum and a monthly annuity pension depends on various factors, including your financial goals, marital status, legacy plans, risk tolerance, other sources of retirement income and personal preferences.
How an adviser can help
Seeking guidance from a qualified financial adviser can help you make an informed decision that aligns with your unique circumstances and provides financial security throughout retirement.
Here are some ways an adviser can provide personalized help so that you can feel confident in your decision:
An adviser can analyze your overall financial situation, including other sources of retirement income and assets, to determine how much income is required to support your desired lifestyle.
Using sophisticated financial modeling tools, a financial adviser can project the potential outcomes of a lump sum payout versus an annuity over your lifetime.
A financial adviser will assess the tax implications of both options.
Considering your life expectancy and family situation, an adviser will explore the impact of the chosen payout on your beneficiaries and potential inheritance.
Once a decision is made, an adviser can assist in implementing the chosen payout option and provide ongoing monitoring and adjustments as needed, ensuring your retirement plan remains on track.
If you are approaching retirement and face the critical decision of choosing between a lump sum and annuity pension payout, an Advance Capital Management financial adviser can help you explore your options during a free financial consultation.
Bill works closely with people to help them achieve their financial goals. As a financial adviser, he guides clients toward making proper decisions during all stages of their financial lives. He provides comprehensive wealth management services such as retirement planning, tax planning, investment portfolio strategies and 401(k) advice. He is a CERTIFIED FINANCIAL PLANNER™ professional and co-host of the finance YouTube channel, Under the Buttonwood Tree.