Lump Sum or Annuity? Ask These 5 Questions First

If you have a pension, you’re one of the few Americans who still does. Once common among retirees, defined benefit pensions have become somewhat of an endangered species in America over the past 40 years.

Following a few incredible pension disasters in local governments and private companies (e.g. Studebaker), American employees began asking for control of their own retirement funding though tax-advantaged accounts like 401(k)s. For better or worse, the system of using a company for both your employment and retirement is disappearing.

Unfortunately, even if you have a pension, it is difficult to know how to make the best use of it. Pensions are often customized to a company and may have various rules about the benefits they provide and the number of years of service required before they can be accessed.

Pension Options

At their most basic, pensions are defined benefit plans that are funded throughout your career and make payments after you retire. In many cases, the pension will continue to make payments for the remainder of your life. If you are married, you may be able to choose whether your pension pays a “single” or “joint” amount. Single benefits pay at a higher rate but will only be active during the employee’s life. Joint benefits pay out less money but can transfer between spouses, allowing the pension to be used for the full extent of both spouses’ retirements.

Most pensions also give you the option of taking your money as a lump sum. This may be rolled over to an IRA to avoid immediate taxation. The decision to do so, however, should not be made lightly. Depending on how you reinvest the pension money, taxes could cause major short-term problems.

Before arriving at a decision on whether to take your pension in annuity or lump-sum form, ask yourself and your advisor these questions:

  1. How strong is the company providing the pension?

Pensions are ultimately handled and funded by companies; they cannot exist without them. If a business undergoes extraordinary losses, it is possible for a pension to become underfunded or even be shut down. In these cases, pension benefits to current retirees are often reduced or terminated. For a pension to last, the company must be strong enough to support it throughout your whole retirement.

Fortunately, the government laid down several laws to reduce the chance of failures in company pensions. Most of these laws involve how a company invests pension money and the total percentage of obligations they must have access to at any given time. Though complete failures are rare, reduction of pension benefits has become a common problem for many retirees among both the public and private sector. The U.S. also created the Pension Benefit Guaranty Corporation (PBGC), which insures most private-sector plans. If a pension plan is terminated, the PBGC will step in to continue benefits, though it may reduce the amount and/or type of benefits you receive. Despite their guarantee(s), pensions are not without risk. Your retirement plan should consider the possibility of pension complications.

A lump sum payment may be preferable if you have serious doubts about the financial viability of your company’s future. If such concerns are your primary reason for taking a lump sum, you should check to make sure they are both rational and serious before taking any action; mistakenly taking a lump sum can greatly damage the security of your retirement. To find out more about your individual plan, request a copy of the “pension funding notice” from your employer, or look online at FreeERISA at http://freeerisa.benefitspro.com/.

  1. How long will your retirement last?

Generally, the longer you are in retirement and collecting from a pension, the more the pension is worth taking. In contrast, a lump sum is worth more the shorter your expected retirement period. Estimating how long you will be in retirement depends largely on when you plan on retiring as well as you and your spouse’s expected longevity. For instance, in cases of terminal or serious illness, a lump sum will likely get a person more of the pension money they have earned (unless they have a joint plan with a spouse). However, a couple who both have healthy family histories with long life expectancies will likely benefit more from annuitization.

However, even if an annual benefit is worth more as a result of longevity, it doesn’t mean it’s the right choice. More years in retirement also means that you have more time to invest a lump sum and watch it grow, especially if you don’t have to take distributions right away. However, that all depends on your overall financial plan.

  1. How will a lump sum or an annuity fit with the rest of your portfolio?

If you already have enough guaranteed income secured through Social Security, annuities or trust disbursements, you may wish to take out your entire pension as a lump sum to increase the flexibility of your retirement spending. If, however, you have very little guaranteed income outside of your pension, the annuity may be the better choice. If your pension will begin benefits too early, it could be better to take the lump sum and invest it elsewhere to let it grow until you are ready to retire.

  1. How successfully can you manage a lump sum if you take it?

A lump sum saddles you with the responsibility of successful management of a larger retirement account. If you’re planning on managing the money yourself, but haven’t had a good track record of investing or you’re prone to withdrawing money too quickly, it may be better to let the pension manage your money. Alternatively, it may be best to take the lump sum, give management of the funds to your trusted advisor and make a long-term plan for the money.

  1. Does the annuity meet your needs?

If you are planning for a lengthy retirement, be careful not to overestimate your pension income. Most pensions pay out at a fixed rate and do not keep pace with inflation. Under normal inflation rates (3 percent), your pension will halve in value in about 24 years. Your pension may also seek to begin benefits before you planned to retire (sometimes as early as age 55), increasing the effects of inflation on the income late in retirement.

Pension income is almost always taxed as a part of regular income. The only exception to this is when a pension is taken as a lump sum and rolled into a tax-advantaged retirement account, at which point the account distributions will still be taxed as income. Rolling a pension over can be a complex problem that is influenced by your age, current employment and special pension rules. It is imperative that you do not attempt to roll over a pension without professional financial advice.

This article was written by Advicent Solutions, an entity unrelated to Advanced Wealth & Retirement Planning, LLC. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Advanced Wealth & Retirement Planning, LLC does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. © 2014 Advicent Solutions. All rights reserved.