Dear Carrie: I’m about to retire, and I have to decide between taking a lump sum or lifetime income payments for my pension. I’m leaning toward the lump sum. Is this a good idea?—A Reader
Dear Readers: My first thought is to say congratulations! A pension in any form—whether taken as a lump sum, as lifetime income (sometimes called a pension annuity) or as some combination of both, is a valuable and increasingly rare benefit. This is an important retirement decision. Take your time and weigh all the options carefully. A lump sum can seem alluring, no doubt, but consider tax implications as well as the potential benefits of spreading out payments over a longer period of time.
I also want to point out that one choice isn’t universally better than others. The best choice for you will depend completely on your individual circumstances. Let’s take a look at some of what you need to consider before making this very important decision.
Start by Understanding the Math
As you start to do your analysis, it can be helpful to compare the raw numbers. As an example, let’s say you’re trying to decide between a $300,000 lump sum or lifetime income of $2,000 per month. This amounts to an annual return of 5.17 percent if you live another 20 years. In other words, if you were to take the lump sum and invest it on your own, you’d have to earn an average annual return of 5.17 percent to equal income of $2,000 per month for 20 years.
However, this isn’t quite an apples-to-apples comparison. The lifetime income payments include a return on some of the original contributions along with investment returns. Additionally, it is guaranteeing you’ll receive the same amount of income if you live beyond 20 years. The 5.17 percent from investing the lump sum is a return on your money. Your actual investment results may wind up better or worse than this—with no guarantees.
Complicating the analysis is whether income from your pension has a cost-of-living adjustment (COLA), which can increase your payments to help keep up with inflation. This is a major factor because, without a COLA, you can lose considerable purchasing power over time.
Your Health and Life Expectancy Are Key
Let’s continue with the example above. If you take the lump sum, the longer you live beyond 20 years, the higher your annual return will need to be to match the lifetime income payments. Conversely, the shorter your life, the more valuable the lump sum. Take an honest look at your health and family history of longevity before you make your decision.
Think About the Impact on Your Loved Ones
If you opt for lifetime income payments, you may have choices that would reduce your monthly payments but continue to pay lifetime income to your spouse or another survivor. A lump sum, on the other hand, could provide more flexibility or benefits for other beneficiaries.
Consider the Rest of Your Finances
If you have considerable financial resources—brokerage, 401(k), IRA, business assets—and other sources of reliable monthly income (for example, Social Security or rental income), you may have less of a need for another source of lifetime income. Taking a lump sum could help you pay off debts. On the other hand, if you’re concerned about covering your essential monthly expenses and you like the idea of having a source of guaranteed monthly income, that could favor the annuity over a lump sum.
Be Honest About Your Investing Skills, Interest, and Desire for Control
Managing a lump sum takes skill and discipline. If you work with a financial adviser or if you’re an experienced investor and you’re willing to put in the time, the lump sum could be a good fit, but make sure to consider fees. However, if you’re uncertain about your investment ability or you would rather spend your time doing other things in retirement, lifetime income could be a better choice.
Weigh Your Risks
Either choice involves a certain degree of risk. If you choose a lump sum, your employer transfers all investment risk to you. You could do better—or worse—than the lifetime income option. Another concern is longevity risk, or the possibility that you’ll overspend and run out of money.
On the other hand, there are risks with choosing lifetime income—for example, dying prematurely, missing out on better investment returns, or having the pension assets lose value if the plan isn’t adequately funded. The federal Pension Benefit Guaranty Corporation (PBGC) provides a certain amount of protection for private pension participants; if you work in the public sector, your employer generally offers guarantees through the federal, state, or municipal governments.
Think About Taxes
If you take monthly income, your payments are subject to ordinary income tax. If you take a lump sum in cash, it’s immediately taxable and you’ll be subject to 20 percent federal (and potentially state) mandatory tax withholding. With a few exceptions, distributions taken prior to age 59 1/2 are subject to a 10 percent early withdrawal IRS penalty. Withdrawals do not need to begin until age 72.
Alternatively, you could likely roll over the lump sum into a traditional IRA or potentially into another employer plan and defer taxes until you take withdrawals in the future.
You May Have More Than One Option
Sometimes you don’t have to make an all-or-nothing decision. Depending on your plan, you may be able to take a portion of your plan balance in a lump sum and the rest in a series of income payments. Other options might include starting the pension at a later date. Be sure you understand the details and how these arrangements would impact your total payout.
As you can see, choosing between a lump sum and lifetime income payments is a complicated decision. As you weigh your options, it can be very helpful to consult with a trusted financial adviser. If you’re married, it’s also essential to consider your spouse. Your choice will impact both of you for many years, so take the time to make an informed decision.
Whatever you decide, congratulations on your retirement. You’ve worked many years to earn your pension; now you get to enjoy its benefits.
Note: Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Annuity guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company or entity that pays the lifetime income.
Carrie Schwab-Pomerantz, a certified financial planner, is president of the Charles Schwab Foundation and author of “The Charles Schwab Guide to Finances After Fifty.”