How to Take Your Pension: Lump Sum or Annuity?
Employers like GM are increasingly forcing retirees to choose a payout option. Before you decide, consider these factors.
Bonnie Kirchner is a Certified Financial Planner and the founder and owner of $ea Change Financial Education.
Since more and more companies are looking for ways to take their pension plans off their balance sheets, you could soon find yourself facing a similar dilemma.
That's why it's important to know how to weigh the annuity vs. lump sum options. The choice you make will not only affect your retirement, it could also impact the financial futures of your spouse and children.
Factors Retirees Should Consider
There's no one right or wrong answer. Choosing between an annuity or a lump sum depends on many factors, including your other financial resources, risk tolerance, investment prowess and your family's needs.
(MORE: Are You Saving Enough For Retirement?)
Here's how the two choices stack up:
Annuities: The chief advantage is that you can expect to receive money month after month for as long as you live — and, possibly, even longer for your beneficiary. Annuities offer assorted payout options, including reducing your monthly checks to allow your spouse to continue receiving the money after you die, for the rest of his or her life.
Continuation of the monthly checks assumes, however, that the company paying the benefits will be around and remain solvent for years to come. For GM retirees, Prudential Insurance will convert their pensions into annuities and then make the monthly payments.
Keep in mind that unlike pensions paid by employers, annuities from insurers are not federally guaranteed. They're covered by state guaranty associations in the event of an insurer's insolvency, and each agency has its own payout limits.
One other drawback of annuities: Unless yours has a cost-of-living adjustment, the monthly payments are fixed and won't keep up with inflation.
Writing in the Detroit Free Press, Karen Friedman, executive vice president and policy director of the Pension Rights Center, said she believes taking the annuity is the "far better and safer option" for most retirees.
Christopher Frayne, a portfolio manager for Sigma Investment Counselors in Southfield, Mich., told The New York Times that he advised up to 80 percent of his clients weighing GM's offer to go for the monthly annuity checks. "To take that lump sum and recreate that income with interest rates this low, that's hard to do," he said.
(MORE: How to Avoid Outliving Your Money)
Lump sum payout There are four arguments for taking a lump sum and then putting it into a rollover IRA:
- You have control and flexibility over the money and its income stream.
- You can choose and update beneficiaries and add contingent beneficiaries.
- The pension won't vanish when you die, the way annuity payments can; what's still left will go to your beneficiary.
- You're only taxed on the amount you withdraw; 100 percent of annuity payments are taxable.
There's also an argument for choosing the lump sum option based on today's low interest rates: By taking the lump sum, you can receive all the cash, wait for rates to rise, and then use some or all of the money to buy your own annuity. At that point, you could potentially see higher monthly payments than what your employer's annuity, invested in bonds with low rates, would provide.
Chris Farrell's Next Avenue article, "How to Avoid Outliving Your Money" has useful guidance about how to shop for an annuity.
If you choose the lump sum payout, however, you're taking on the responsibility of investing the money well enough to carry you through retirement, along with your other savings, income and Social Security.
In effect, you're saying that you — and/or your financial adviser — will be able to earn higher returns than you would by taking the annuity, which is typically a conservative investment.
Years ago, with a well-behaved stock market and low interest rates, having complete control over a lump sum of retirement money was an attractive option. But today, the market can be extremely volatile, as proven in 2008, when stocks dropped precipitously.
In addition, a 2006 law changed the way companies calculate pensions, allowing them to offer retirees smaller lump sums than in the past. Consequently, the lump sum option isn't as attractive as it used to be.
(MORE: The Retirement Math That Matters Most)
Keep in mind, too, that if you take the lump sum, you'll incur investment costs. These include fees to buy and sell investments as well as whatever a financial adviser might charge. (Annuity costs are baked in, so your monthly checks are already reduced by the insurer's fees.)
The bottom line: If you (and your beneficiary) expect to need the monthly checks from your employer's annuity for the rest of your lives, you're risk adverse and you don't want the of responsibility of investing your pension, you may want to go for the annuity.
However, if you feel confident about your investment abilities (or have an adviser you trust to make those decisions) and don't need the guarantee of monthly checks, you may prefer the lump sum.
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