Which is better: pension or payout?

Should a reader retiring at age 48 choose a $350,000 payment or a $1,600 lifetime pension?

By Walter Updegrave November 25, 2005

This article appears at the following website: money.cnn.com

Q. My wife plans to retire in two years at age 48. When she does, she has the choice of taking a $350,000 lump-sum payment or having her company pay her a pension of $1,600 a month for life. What would you advise?

-- Jim Akins, Cushing, Oklahoma

A. While I'm sure a lot of people would love to be in your wife's position, the truth is that she does face a major decision here -- one for which there is no "correct" answer.

Let's take a look at a few of the factors your wife should consider.

The main attraction of taking the monthly payments is that you don't have to worry about managing that lump sum in a way that assures it will last the rest of your life. The company, in effect, does that for you, so you have the perceived security of a lifetime income.

Notice I said "perceived" security. I make this distinction because this monthly pension payment depends for the most part on your company's ability to pay it for many, many years to come.

In recent years, we've seen a number of companies -- most notably steel makers and airlines -- renege on those promises after running into financial problems. So by accepting the monthly payments, you're tying your economic future to that of your company. That's a difficult bet to gauge, since a company that appears healthy today could easily run into trouble in the decades ahead.

Ultimately, if you're not comfortable handling a large sum of money and you're wary of going to an adviser for help, then the monthly payments can be an acceptable decision. But once you take the monthly payments you won't have access to the lump sum and you could restrict your financial wiggle room.

If, on the other hand, you want more control over your money, then taking the lump makes more sense, and the lump-sum option gives you the option of creating lifetime income while still maintaining access to a portion of your money.

Safety net?

Of course, there is a pension safety net of sorts. When a private company is unable to make its pension payments, the Pension Benefit Guaranty Corp., a federal corporation that insures private pensions, steps in to cover pensioners.

But the PBGC's coverage has limits that vary according to the age of the pension recipient at the time the PBGC takes control of the pension.

What's more, the PBGC itself is under quite a bit of financial stress because the liabilities for the pension plans it has take over far exceed the assets it has to pay those liabilities. Congress is working on a plan to remedy this situation, although it's far from certain how all this will shake out.

Tax strategies

By choosing the lump sum, your wife can essentially separate her fortunes from those of the company, but she'll owe tax if she simply takes the cash.

She can avoid that by rolling the lump sum into an IRA rollover, which will keep her money growing free of taxes.

Once she has the money in an IRA rollover, she has several choices. She can manage the money on her own by investing in stocks, bonds or mutual funds that she chooses or she could have an adviser help her do so.

In that case, she can make withdrawals from her account as she needs the money. But keep in mind, withdrawals before age 59 and a half will be subject not just to tax at ordinary income rates, but a 10 percent penalty as well.

The annuity option

She also has the option of turning the lump sum within her IRA rollover into lifetime monthly payments by buying an income annuity (aka an "immediate" or "payout" annuity) from an insurance company.

It's important that the annuity itself remain within an IRA. If your wife just withdraws money from the IRA and then buys the annuity, she'll have to pay tax and possibly the 10 percent penalty on the withdrawal.

The size of the payment your wife would receive will vary from company to company, but when I went to Immediateannuities.com -- which gives an average of what several insurers would pay -- and plugged in your wife's info, I found she could get monthly payments for life of about $1,700 a month.

Moreover, your wife doesn't have to convert the entire lump into an annuity. She can "annuitize" just a portion of it and leave the rest in the IRA rollover. This way, she can get some income immediately while allowing the rest of her nest egg to grow.

A caveat: if your wife takes annuity payments from her IRA, she'll owe income tax on those payments, but she won't have to pay the 10 percent penalty even if she's under age 59 and a half.

The reason is that Congress carved out an exception to the 10 percent penalty for people who take IRA withdrawals in the form of "substantially equal periodic payments" based on their life expectancy.