Lump Sum Versus Payments for Life

One option gives flexibility, the other peace of mind. Our expert says you can have it both ways.

Q:

When I retire, I'll be eligible for a pension from two companies. My question: should I take my pension in a lump sum or in annuity payments that will last the rest of my life? I'm leading toward a lump sum because I figure by investing it I can better hedge against inflation. Do you think that's the best approach?

A:

Let's look at the pros and cons of both options - and then consider a compromise that I think makes a lot of sense for most people.

First, let's take a look at the case for an annuity.

Here, your employer offers to make monthly payments that will last for the rest of your life. If you're married, your employer will make payments as long as you or your spouse are alive, an arrangement known as a "joint and survivor" annuity option. You can choose to have payments based on your life only, but your spouse will have to sign off on that decision.

Annuity Pros

The advantage to the annuity is certainty. You know that a check is coming in the mail each month and you know exactly how large that check will be. You don't have to worry about investing your money or dealing with the ups and downs of the financial markets.

That sort of reliability is a good deal not just for financial reasons but for emotional and psychological reasons as well. Retirees get considerable satisfaction knowing that their check will arrive like clockwork each month - and that the income will keep on flowing no matter how long they live.

Indeed, research shows that retirees who have pension income tend to be happier than those who don't.

Annuity Cons

As enticing as guaranteed pension income is, however, it does have its shortcomings. One is that most corporate pensions, unlike Social Security, do not increase their payments with inflation.

Let's say you get a pension payment of $1,000 a month. Even if inflation were to mosey along at a modest pace of 2% per year, the $1,000 in goods and services your check buys today would cost $1,346 in 15 years.

Another drawback is that monthly payments aren't much help if you need a sizeable sum of cash to meet an unexpected expense - a medical bill, say, or a home repair - or if you would just like to indulge yourself with a little splurge such as a nice cruise.

You should also know that while people talk about pension payments as being guaranteed, actually they're not. You're counting on your company (or any company that may acquire your employer in the future) having the financial wherewithal to be able to make those payments years and years into the future. We already know that once healthy companies sometimes run into problems that may lead them to renege on their pension promises.

There is a federal agency (the Pension Benefit Guaranty Corp.) that steps in to pick up the slack. But the PBGC's protection has limits. (See details.)

Lump Sum Pro

If you take the lump sum, you have more control over your pension money. You decide how much to draw from the pot each month and if you need a bit extra for any reason, you can easily dip into your stash for ready cash.

Lump Sum Cons

But with that greater flexibility also comes more responsibility. You've got to invest and manage your money so that it will last the rest of your life, and so that it will stand up to inflation.

That means deciding how to divvy up your stash between different types of stocks and bonds (or, more likely, stock and bond mutual funds) and figuring out how much you can safely withdraw each year so you don't risk running out.

This is certainly doable - and I've outlined a plan for doing so many times. But it does require a bit of thought and attention on your part.

It's also important to remember that, while you do have more control with a lump sum, it's not absolute control. You can't decide what returns the financial markets will deliver, nor do you have a say in when the market will go into one of its periodic swoons. And you have zip to say about how long and deep a setback might be.

A Compromise

But there is a third way: Why not get the benefits of both worlds?

That is, the convenience, reliability and security of regular annuity payments plus the flexibility and inflation-protection of a lump sum.

And, in fact, there are a couple of ways you can do this. One would be to take the lump sum from one employer and the annuity from another.

Perhaps a better way, though, would be to take the lump sums from both employers and roll over that money over into an IRA. Once you've got your pension in the IRA, you can then use a portion of it to buy an immediate annuity (aka an income annuity).

Like a company pension, the immediate annuity will pay you a monthly income for the rest of your life, except that payment comes from an insurance company rather than your employer.

In effect, you've gotten something very much like a company pension, while still having a portion of your pension money in the form of a lump sum that can provide inflation protection and liquidity to meet unanticipated expenses or fund the occasional splurge.

Before you embark on this strategy, you'll first want to compare the size of the payments your employer is offering versus what you can get from insurers. You can do that at ImmediateAnnuities.com.

I wouldn't be surprised if your company is offering a somewhat higher payment. But, remember, even if you have to give up a bit in monthly payment, you're gaining something in flexibility by not having to take your entire benefit in monthly payments (and by not having to link your fortunes to those of your company for the rest of your life).

You'll also have to consider how you want to divvy up your pension between annuity payments and lump sum. That's largely a personal decision that will depend on a variety of factors, including what other assets you have to draw on, how much of your living expenses will be covered by Social Security and how comfortable you are managing a lump sum.

But the idea is to devote enough to the annuity to get the satisfaction and security that monthly payments can bring, while still having enough as a lump sum to give you ready cash and inflation protection.

Remember too that you always have the option of converting more of your lump sum to an annuity in the future if you wish.

One final thing: don't wait until your last day on the job to start thinking about this issue. Do some research now by collecting information from your HR department on exactly what you'll get in an annuity or a lump sum and compare those with what you could get on your own.

And if you don't feel comfortable doing this sort of research on your own, then consult a financial planner.

But this decision will affect your retirement in a big way, financially and emotionally. So give it the time and attention it deserves.