Increasingly, employers that offer defined-benefit retirement plans (pensions) are offering all or some former employees the choice of either a lump-sum payment or an annuity. For employers, lump-sum payments are advantageous because they save the trouble of having to keep track of former employees’ address and bank account information so they can send annuity payments.
Also, the Pension Benefit Guaranty Corporation, which protects retirees’ benefits in case former employers go out of business, requires employers to pay premiums for each retiree; giving lump-sum payments exempts the employer from having to pay these premiums.
Therefore, employers have a strong incentive to offer lump-sum payments. For employees, this leaves them with an often difficult choice. The employer often gives you a limited period of time, such as a month, to give them your decision. The employer also may provide you with materials to help you decide, but a study by the Government Accountability Office found that such materials often omitted important information.
The GAO report is recommended reading if you’re faced with such a decision. It indicates eight questions that workers should ask when deciding between a lump-sum and an annuity. The biggest question many people have is: which is worth more, a lump sum or regular annuities?
One way to look at it is this: if you took the lump sum and invested it, would the income you receive be greater or less than the amount of the monthly annuity?
The historical average return of the stock market is 7 percent per year. Multiply the monthly annuity amount by 12 to get the yearly annuity amount. Then compare that to the lump sum. If the yearly annuity amount is more than 7 percent of the lump sum amount, you might consider taking the annuity. If the yearly annuity amount is less than 7 percent of the lump sum amount, you might consider taking the lump sum.
There are other considerations of course. Taking an annuity means you will have a guaranteed income stream, possibly for the rest of your life. Moreover, your spouse may be entitled to receive all or some of the annuity if they survive you.
However, there are some drawbacks to annuities. Most private company annuities aren’t adjusted for inflation. So over a 20- or 30-year retirement, inflation may erode away the value of an annuity. Also, taking an annuity means you may not have access to enough cash to handle a large, unexpected expense.
If the employer goes out of business, they will no longer be able to pay the annuity. In that case, the Pension Benefit Guaranty Corporation is supposed to make payments instead, up to a dollar limit per month. But the PBGC itself is operating at a deficit of over $20 billion.
A lump-sum payout may give you more flexibility, since you’re free to invest and use the money as you see fit. You may be able to get a higher return than the annuity would have given you, for example by purchasing your own annuity or investing in dividend paying stocks. But with a lump-sum you are responsible for making sure the funds last for your entire life; many people are tempted to make large purchases which mean they will have less for later.
There are also tax considerations: the payout may be taxable as ordinary income, and may push you to a higher tax bracket for that year.
If you are faced with the choice between a lump-sum payment and an annuity, you should take your time and carefully consider the implications of each choice. Gather as much information about each choice as you can from the employer. Check for any errors in your payment record that might affect your payout. Examine your retirement plan and budget to see how much income your will need. Then look at your expected expenses and other income sources in retirement, and consider talking with a qualified financial consultant.
For additional information
The Consumer Financial Protection Bureau has a guide to deciding between a lump sum and a monthly payout.
For more information about choosing between an lump sum and an annuity, see this article.