Deciding whether to take a lump sum or an annuity from your pension can feel overwhelming. The choice significantly impacts your financial future, and there’s no one-size-fits-all answer.
Most financial experts advise against receiving all your pension funds upfront due to the potential tax bite and risk of outliving your money. However, in some situations, a lump sum payout can make sense.
In this article, we’ll explore the pros and cons of each option. We’ll also discuss some key factors to consider when making your decision.
Understanding your options
You’ve worked hard for your retirement, and now you’re faced with a huge decision about your pension: Will you take a lump sum or an annuity?
A lump sum is a one-time payment representing the total value of your accrued pension benefits, discounted to reflect the time value of money. This cash influx offers maximum flexibility, allowing you to invest, spend or save however you want.
On the other hand, an annuity is a financial contract that guarantees a steady stream of income for a specified period (in the case of a pension, for the rest of your life). It’s essentially an insurance policy against outliving your savings.
Lump sum option
A lump sum payment offers complete control — and a lot of responsibility. You’re in the driver’s seat when it comes to how to allocate your money, but you’re also responsible for ensuring it lasts the rest of your retirement.
If you feel confident managing a large sum of money, a single payout comes with some potential benefits:
- Investment potential: You can invest in a variety of assets, such as stocks, index funds or real estate. If your investments perform well, you could potentially generate higher returns than an annuity.
- Flexibility: You can use the money for any purpose, including purchasing a second home or starting a business.
However, with great freedom comes a lot of responsibility. Here are some of the downsides:
- Investment risk: Managing a lump sum requires financial knowledge and a willingness to tolerate market fluctuations. Poor investment decisions could erode your retirement savings.
- Longevity risk: If you live a long life, you may outlive your savings, leading to financial hardship as you age.
- Tax implications: Lump sum distributions are subject to income tax. You could get hit with a huge tax bill.
Annuity option
An annuity provides a reliable income stream, offering a sense of security in retirement. Your payments arrive at the same time every month, typically for the rest of your life.
This so-called “retirement paycheck” can be especially appealing if you’re risk-averse. Some other benefits of annuities include:
- Longevity protection: Many annuities ensure payments will continue your entire retirement. This protects against the risk of outliving your savings.
- Simplified financial management: A monthly pension payment offers financial security and simplicity. The pension plan handles investments and determines your regular payout, shielding you from market fluctuations and the complexities of financial management.
But annuities come with their own set of drawbacks:
- Less flexibility: Once you annuitize your pension, you generally can’t access the lump sum. If you need a large sum of money for an unexpected expense, you may be out of luck.
- Fees and surrenders: Most annuities have fees, surrender charges or limitations on withdrawals.
Partial lump sum and annuity: The best of both worlds?
Some pension plans offer a hybrid option that combines the benefits of both a lump sum and an annuity.
For example, you might choose to take 30 percent of your pension as a lump sum and convert the remainder to an annuity. This approach can provide cash now while also ensuring a steady income stream later.
Unfortunately, few pension plans offer the flexibility to combine lump sum and annuity payments, according to the Consumer Financial Protection Bureau. In fact, if your pension is relatively small, taking both might not be feasible.
Taking a lump sum and buying a private annuity
Another option is taking a lump sum and using it to purchase a private annuity from a life insurance company. However, this option — sometimes called a pension annuity — doesn’t make sense for most people.
Often, private annuities offer less favorable terms compared to pension-provided annuities. Be prepared for lower monthly payments than you would have received from your original pension. Annuities on the private market typically come with higher fees and expenses, reducing your overall return. Additionally, women often face higher costs for annuities due to their longer life expectancies.
To get a sense of potential annuity payments based on your lump sum, use an annuity calculator. Keep in mind that these calculations are estimates and may not accurately reflect the actual payments you would receive.
Lump sum vs. annuity: 6 factors to consider when making your decision
Everyone’s financial situation is different, so it’s important to consider a few key factors — such as tax implications, your life expectancy and even the financial health of your pension provider — when making your lump sum vs. annuity decision.
1. Your life expectancy
One of the greatest uncertainties retirees face is how long they will live. Both annuities and lump sums are based on actuarial calculations, which estimate life expectancy. However, these calculations may overlook individual health and family history.
If you anticipate a longer-than-average lifespan, the steady income of an annuity can provide peace of mind. However, if you have multiple chronic health conditions, a terminal illness or a family history of shorter lifespans, a lump sum might offer more flexibility to enjoy your money.
2. Your family
You’ll also want to consider your dependents and heirs when making your decision. If you have a spouse or children who rely on your income, a joint and survivor annuity can provide continued financial support after your death.
On the other hand, a lump sum opens up more estate planning options — assuming that you don’t spend down the money in retirement. You could, for example, fund a trust with the money, which can give you total control over how funds are distributed after your death.
Also keep in mind that if you’re married, your spouse will likely have to give written consent for you to take a lump sum payout.
As an alternative, some couples find creative solutions by taking a lump sum from one spouse’s pension and opting for monthly payments from the other.
3. Income needs
Next, carefully assess your desired retirement lifestyle and estimate your annual expenses. Consider factors such as housing costs, health care expenses, travel and hobbies when determining your income needs. Create a detailed budget to estimate your costs, as well as all sources of income.
An annuity provides a predictable income stream, which can make it easier to budget and plan for future expenses.
Meanwhile, a lump sum requires careful investment planning and budgeting to ensure a consistent income. A lump sum could be a good choice if you’re dealing with serious health issues or if you and your spouse have enough income to comfortably meet your monthly expenses in retirement.
4. Your risk tolerance
Your comfort level with investment risk is a critical factor in deciding between a lump sum and an annuity.
A lump sum exposes you to a lot of risk. Invest the money too conservatively, and it might not last. Invest or spend it too aggressively, and the same dreaded outcome is possible. But if you have a high risk tolerance and are comfortable with the potential for both significant returns and losses, a lump sum might be suitable.
However, if you prefer a more conservative approach and want to protect your retirement savings from market volatility, an annuity offers more reliability.
5. Taxes
If you choose a lump sum, you’ll owe income tax on the entire amount unless you roll it over into an individual retirement account (IRA) or another qualified retirement plan. However, this isn’t always an option, so check with your plan administrator.
If you don’t roll the money into an IRA, a large lump sum could push you into a higher tax bracket. Also keep in mind that you won’t receive the entire amount upfront — your employer is required to withhold 20 percent of the payout for taxes. If you’re under 59½, you may also face a 10 percent early withdrawal penalty.
With an annuity, you’ll pay income taxes each year on the amount you receive. However, these smaller payments are less likely to bump you into a higher tax bracket.
6. Financial health of your pension plan provider
Some pension funds struggle with underfunding issues. To stay informed about your plan’s health, you can access the plan’s Form 5500 on FreeErisa.com. This form will detail the plan’s current assets, liabilities and most importantly, the funding percentage. Ideally, this percentage should be close to or exceed 100 percent.
If you have concerns about your pension plan’s provider, it’s important to know that the Pension Benefit Guaranty Corporation (PBGC) typically insures your pension. This federal agency guarantees your payments up to a certain amount if your employer goes bankrupt or defaults on payments. However, if you choose to take a lump sum payout, you forfeit these protections.
If you’re deeply concerned about your pension provider’s ability to pay out long term, you could take a lump sum distribution then purchase a private annuity on the private market. This way, you can invest the money with a financially strong life insurance company, minimizing the risk of default.
If you go this route, look for companies with “A” ratings from agencies like A.M. Best or Standard & Poor’s. While state guaranty associations offer some coverage (usually up to $250,000) if an annuity issuer becomes insolvent, it’s best to avoid this scenario altogether by choosing a financially stable insurer.
By understanding your plan’s health and the potential drawbacks of a lump sum payout, you can make informed decisions about your retirement income. Consider consulting with a financial advisor for personalized advice tailored to your specific situation.
Bottom line
Choosing between a lump sum or an annuity for your pension is a major decision. A lump sum offers flexibility while an annuity offers predictability. Everyone’s situation is unique, which is why it pays to speak with a financial advisor. Ultimately, though, pensions are meant to serve as a safety net in retirement. Don’t leave yourself exposed to risk by forfeiting that stability unless you’re absolutely sure it’s the right move for you.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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