How you choose to receive your pension or annuity is a big decision. Both a pension and an annuity are retirement income sources, but they perform in different ways.
You can't change your mind, and your choice will affect your level of retirement security for the rest of your life. If your company gives you options, you need to weigh the pros and cons of taking a lump sum versus taking an annuity distribution before you make this permanent decision.
Some companies require you to take your pension income in the form of an annuity payout. This method offers monthly payments for life. However, more and more companies are giving you the option of taking your pension as a lump-sum distribution instead of an annuity payout. In some cases, you can take part of it as an annuity and part as a lump sum.
Below are the items to think about and an example of how to do the calculations to compare options.
- Both annuities and pension plans allow you to choose between lump-sum distributions and regular payments.
- The biggest risk with lump-sum distributions is that the money won't be managed properly.
- Steady payments are easier to manage. Still, there are risks when it comes to inflation rates or the financial stability of the company issuing your payments.
Pensions vs. Annuities
Pension plans are accounts that have been funded over time with contributions by a worker and an employer. Many factors contribute to the value of the retirement fund. Depending on the type of plan, the funds are invested and grow for the use of the employee on retirement. Pension plans are insured by the Pension Benefits Guaranty Corporation (PBGC). Examples of pension plans include a 401(k) or the military retirement that many Americans receive. These plans can be:
- Defined-benefit: The employer guarantees a set amount on retirement.
- Defined-contribution: The employer and the worker contribute to specific degrees.
Annuities, on the other hand, are complex insurance-type products. They come in many types. The owner will purchase the annuity policy and fund it in a lump-sum payment or with payments stretched out over the years. Funds are invested by the insurance professional and are used to make payments later. The contract will define when the owner may begin to take payments and how long they will last. Since the owner opens the annuity, they can set it up to suit their future needs.
Withdrawing Your Funds
The owner of either an annuity or a pension plan may decide to take the value of the fund as a lump sum or as regular payments. If funds were deposited into the account after they were taxed—like with a Roth IRA—they can avoid paying taxes when they are used.
Since most people expect to have a lower tax burden in retirement than they do during their working years, many will opt to deposit pre-tax dollars into the accounts.
Like many people, you may like the idea of taking a lump sum. With immediate access to the money, you can use the funds as you please. You may even invest the funds into other income-producing investments. If managed well, you may be able to earn the same amount of income that the annuity would provide through its regular payments. In this case, you also retain control of the principal to pass along to heirs.
However, you might not think about the risks of taking the lump sum. Having access to a large sum of money makes it easy to spend it too quickly. If the money is badly managed or invested poorly, or if the markets don't do well over your first 10 years of retirement, you may run out of money.
A pension or annuity plan with a decent payout rate has some big advantages. You will have a guaranteed income for life, so you won't outlive your income. The remaining funds will continue to be managed and invested. You will not have investment-management decisions or responsibilities. However, like the lump-sum option, payouts also have a downside.
If you have a large pension plan, a portion of your future benefits guarantee is based on the financial stability of your former employer. Benefits could be reduced if they do not properly manage their pension fund. But with most pensions, a portion of your pension benefit is insured by the PBGC. This amount is adjusted each year and depends on the year you retire.
The fixed monthly amount might not keep pace with inflation. Some pension benefits have a cost-of-living adjustment built-in, but most do not.
Example of an Annuity Distribution
Joe is age 62, about to retire, and he has the following options as to how he collects his pension:
- Single life annuity: $2,250 per month
- 50% joint and survivor annuity: $2,078 per month
- 100% joint and survivor annuity: $1,931 per month
- Life annuity with 10 years certain: $2,182 per month
- Lump-sum one-time distribution: $347,767 to be rolled over to his IRA
If Joe chooses the single life annuity option, he will receive $2,250 for as long as he lives. The monthly benefit stops when he dies. If he lives only one year, no additional funds will be paid out. If he is married, his spouse will not receive a survivor benefit.
If Joe chooses the 50% joint and survivor annuity option, he will receive $2,078 per month. Then, upon his death, his spouse will receive $1,039 per month as long as she lives.
If Joe chooses the 100% joint and survivor option, he and his spouse will receive $1,931 per month for as long as either of them is still alive. In that scenario, Joe is taking $319 less per month. That way, his spouse will continue to have a substantial benefit upon his death. Think of that $319 per month as buying life insurance.
Distribution and the Internal Rate of Return
To figure out whether a lump sum payment is better than a steady payout, Joe must calculate the internal rate of return of the annuity. He will compare that to the expected internal rate of return on the investments he would make if he were to take the lump sum.
To calculate the internal rate of return of the single life annuity pension choice, Joe should consider a few life expectancy options. First, use the present value of $347,767, monthly payments of $2,250 every month for 20 years, and nothing left over at the end. This equates to a 4.76% internal rate of return. Then use the same numbers, with payments for 25 years. That equates to just over a 6% internal rate of return and gets Joe to age 87, which is a reasonable life expectancy estimate to use.
For the 100% joint and survivor annuity option and a 25-year payout, the rate of return is 4.49%. If Joe's wife is younger, and a 30-year payout occurred, that bumps the return to 5.29%.
If Joe takes a lump-sum distribution, he will receive $347,767. He could then choose to invest these funds in any way he wishes. If he follows a disciplined set of withdrawal rules, he may be able to create an income stream of 5% per year. He may also be able to increase this income each year to help offset the effects of inflation and retain control of his principal. Still, he would need to follow a consistent investment strategy over a long period of time to do that. And, there are no guarantees that it would work in all market conditions. If it would work, here is the income Joe might expect:
$347,767 x .05 (5%) = $17,388 / year initially, or $1,449 per month, with an expected increase each year to help offset the effects of inflation. (By the time Joe were to reach 82, if the investments were able to support a 2% increase per year, his distributions would increase to $2,239 per month.)
Using a present value of $347,767, monthly payments of $1,449 that increase each year by 2% per year and Joe's single life expectancy of about 20 years, and future value of $347,767, this would equate to an internal rate of return of about 6.5%, assuming that the funds were managed appropriately, thus providing the inflation-adjusted distributions while maintaining principal.
Comparing the Risks of the Options
The question now is, "Is the additional potential return worth Joe taking on the risk of managing the assets himself?" Some people do not feel comfortable with the funds remaining in the company's pension plan. Others do not feel comfortable rolling the funds out of the plan to an IRA and managing it themselves or hiring someone to do it.
You must weigh the pros and cons, and the equivalent rates of return, and make your own choice. In the past, about one-third of the time, a well-managed portfolio would have achieved an average annual internal rate of return that was less than 6%. That is because something called "sequence risk" can have a big impact on your returns when you are drawing money out. Don't rely on the market to deliver above-average returns after you retire.
Many annuity offers are quite attractive, especially if you factor in the potential of living long. Don't pass over the annuity offer without analysis and a strong rationale as to why the lump sum does not make sense in your situation. Compare an annuity vs. an IRA, and decide what's right for you.
Frequently Asked Questions (FAQs)
How do you avoid taxes on a lump-sum payout?
You can avoid taxes on a lump-sum payout by rolling it into a qualified retirement plan. These tax-sheltered accounts can help you avoid taxation at the time of the lump-sum payment, but you may be taxed on your withdrawals from the rollover retirement account.
What is a non-qualified annuity?
Non-qualified annuities are funded with after-tax dollars. This arrangement creates a different tax situation from qualified annuities, which are often funded with pre-tax dollars through employer-sponsored plans.