Pension Planning: Choosing a Lump Sum or an Annuity

 – April 26, 2016
Pension Planning: Choosing a Lump Sum or an Annuity

Should you take your pension in a lump sum or as an annuity payment? Here's how you can determine whether getting a monthly stream of payments for life or getting a large cash payment is right for you (and your spouse).

Define Your Goals

Get a clear understanding of your goals, and know your overall financial picture. For example, do you have other annuities or investment assets? Be sure to consider all your resources when making this prudent decision.

Once you obtain all of your financial information, run the numbers to see how the pension compares to investing the money in a conservative allocation. Usually, the numbers indicate that the lump sum is the better option. This is because pension checks are based on current interest rates, and with the historically low-rate period we are experiencing, you are locking in a low rate of return for the rest of your life.

Ask Questions

Be very honest and ask yourself tough questions. Would you be tempted to use the lump sum for luxury purchases? If you are planning to manage the money yourself, are you equipped to do so? Candidly explore health and longevity issues as well. If someone expects to have a shorter life, then the lump sum is generally the better option.

Consider the Annuity Risk

One drawback of an annuity payment is that pensions are rarely indexed for inflation. With medical costs being one of retirees’ major concerns, and these costs escalating rapidly, this is a major consideration. At an annual three-percent inflation rate, a monthly check worth $2,000 today would be worth only $1,488 in 10 years and $1,107 in 20 years.

Consider the Lump Sum Risk

Educate yourself on the possible average returns of various portfolio allocation models on a historical basis. However, if you stop there you will be doing yourself a disservice. The markets do not get the same rate of return each year. For example, if it looks like a diversified 60/40 (60 percent stocks, 40 percent fixed income) allocation would be appropriate, you need to know that the portfolio could lose approximately 19 percent in a given year. If the lump sum is for $500,000 and in the first year it lost $95,000, determine if that would compromise your retirement. If you moved to a 40/60 allocation, you could reduce the risk down to a loss of around 10 percent, or $50,000. Determine if you're comfortable with that.

Think of Your Heirs

The company annuity ends when the individual and/or the spouse dies — which is why you should consider leaving the rest of the amount to children, grandchildren or another heir. If someone takes the lump sum, then the spouse, children, grandchildren or other beneficiaries would get whatever remains. Because many people have a strong desire to leave an inheritance to heirs, this becomes the deciding factor for taking the lump sum approach.

Consider Taxation

You will owe taxes on every monthly pension statement, but with the lump sum being rolled into an IRA, you don’t have to take the money until age 70 ½, when minimum required distributions take effect. However, you can potentially save thousands of dollars by taking money out of a lump sum IRA earlier than 70 ½ at a favorable tax bracket.

Final Piece of Advice

A CPA or fee-only advisor who doesn’t sell products or benefit from commissions is the best person to help you with this important decision. That advisor should be someone who can run the investment numbers and show you the tax implications over time. Make sure that advisor takes the time to sit down and educate you on all the different ramifications so you can make the best decision about how you cash out your pension.

Talk to a CPA

Certified public accountants can help taxpayers file their returns accurately and, if needed, guide them through the audit process. Locate a CPA near you with our Find-A-CPA directory.