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Pension Payment Plan: Annuity or Lump-Sum?

Some employees are fortunate enough to have a defined benefit pension plan offered through their employer. However, they will have to decide between electing to take their benefit as a monthly pension over their lifetime or a lump sum payout upon retirement. There is typically also a joint annuity option which is similar to the monthly pension, but payments would continue for both the employee and their spouse over their lifetimes. Under the joint annuity option, lifetime monthly payments are typically lower, depending on the percentage of the monthly check they would like to continue for their spouse after passing away. For example, selecting a 50% joint annuity option will provide a higher payment while the employee is alive than a 100% joint annuity option, but would be reduced by 50% once the employee passes away.

There are several factors to consider before making an election.

The first consideration is personal health and family medical history. With life expectancy, the longer you live, the better the decision for an annuity becomes.  Logically, if you took the annuity and then you both passed away quickly thereafter, then selecting the annuity was probably the wrong choice.  Conversely, the longer you live, the more attractive the annuity becomes. 

Another important factor to consider is if you believe that you or your trusted advisor will be able to generate the required rate of return necessary to have the lump sum keep pace with your cost of living and inflation. The required rate of return is predicated on each individual’s living situation and can be assessed through developing a financial or retirement income plan.

For individuals who want to ensure they are passing on a legacy to their next generation, the lump sum would be the more beneficial choice to fulfill this goal. When you select the annuity, you are providing a guaranteed income for yourself or both you and your spouse’s lives.  However, at your passing in the single life-annuity scenario or the second individual in a joint-life annuity scenario, the value of the annuity is gone.  Conversely, if you take the lump sum, you can designate a beneficiary of the lump sum (assuming the lump sum has not all been spent).

Some pensions do offer a cost-of-living adjustment, but most private pensions do not. As we are currently dealing with a rate of inflation that has not been seen in decades, this should be top of mind for individuals considering fixed income streams to sustain them through their retirement years. You will want to find out if your pension plan offers an annual cost of living adjustment or not. For those that are offered a cost-of-living adjustment, that feature typically makes the monthly annuity options more attractive. If the pension does not offer an annual cost of living adjustment and you select the annuity option, keep in mind that the payment is fixed and will not increase over time as inflation sets in.  As your cost-of-living rises, you will need to have other financial resources to fund the gap. 

Another factor that employees often overlook in this decision, but should be considered as well, is the future of the company and its pension plan. If you plan to choose the annuity, you need to feel confident that the pension plan is adequately funded.  If the company falls on hard times, they may not be able to fund their necessary pension obligations, which could jeopardize the financial health of the pension plan in the distant future. Most pension funds are insured in these extreme cases, but you would want to understand how much of your monthly payment could be potentially forfeited in the worst-case scenario.

Other things to consider is your retirement income sources outside your pension. If you are fortunate enough to have other income streams available to you and do not need a large monthly income stream, then you can take the funds as a lump sum and process a direct rollover to an IRA to invest the money tax-deferred. You would then have control over the timing of when you would like to use the funds until you face required minimum distributions at age 72.

Finally, it is important to remember that this decision is irrevocable and should not be taken lightly. You have one chance to get this right and will want to be comfortable with not only your election decision, but also the paperwork and process to prevent delays. If nothing else, consult with a financial advisor to help make a confident choice.

Insight Wealth Strategies, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Insight Wealth Strategies, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Insight Wealth Strategies, LLC unless a client service agreement is in place.

Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Written by,

Michael Agorastos

Michael Agorastos

Michael is a comprehensive, fee-only financial planner who began his financial services career with Insight Wealth Strategies in 2013. His primary areas of expertise cover retirement planning (e.g. cash flow analysis, developing retirement income strategies, stock option planning, corporate benefit analysis, etc.), investment planning, and high-level income tax reduction strategies for individuals and small business owners.