The Pension Payout Dilemma: Pros and Cons of Lump Sum vs. Annuity
Written by
Vance Cariaga
Edited by
Elizabeth Constantineau
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The pension payout dilemma refers to the choice you eventually face when you have a traditional defined-benefit pension plan. At some point, you’ll need to decide whether you want a one-time, lump-sum payout or an annuity that can provide a steady income for the rest of your life. Your decision largely depends on your financial situation and whether you have a pressing need for cash on hand.
Before making the decision, you should research the pros and cons of lump sum vs. annuity for your pension payout.
Pension Payout Dilemma: Lump Sum vs. Annuity
Although it’s not a perfect analogy, you can look at the pension payout dilemma in the same terms as winning a large lottery. With a lottery, winners are typically given the choice between receiving their winnings in a single lump-sum payment or a series of payments spread out over many years. The vast majority pick the lump-sum payment.
“Virtually everybody who wins the lottery picks the lump-sum distribution,” Andrew Stoltmann, a lawyer based in Chicago who has represented lottery winners, told CNBC in an interview late last year. “And I think that’s a mistake.”
The reason so many people prefer the lump-sum payout is because they get cash in hand to spend or invest as they see fit. The same reasoning goes into why some people prefer a lump-sum pension payout. It’s not always easy to look ahead to the future and see the value of steady monthly payments over a lifetime, although that is often the best strategy.
Factors To Consider
Both pension payout options — lump sum and annuity — have their advantages and disadvantages. Deciding on which is better for you depends on a few different factors, including the following:
- Your health — and your spouse’s
- Your life expectancy
- Employment situation
- Net financial worth
- Living expenses
- Debt such as mortgages, car payments, student loans, credit cards and child support payments
- Your investment skills and goals and how they might change as you age
- Family needs
- Other sources of regular income such as Social Security, private retirement plans and pensions from other employers
- Expected taxes on the annuity or lump sum
Reviewing these factors can help you come up with the best decision. For example, if you have a medical condition that could shorten your life, or a major debt to pay off, then a lump sum might be the best choice. On the other hand, if you are expected to live a long time and are not under a mountain of debt, then you might be better off taking the annuity option.
Lump Sum Pros and Cons
Here’s what you need to know about the benefits and drawbacks of a lump sum pension payout.
Pros
- Immediate access to funds: Choosing a lump sum lets you access the full amount immediately to spend, save or invest according to your current needs.
- Investment opportunities: With a lump sum, you have the opportunity for potentially higher returns if you invest the money wisely.
- Estate planning: A lump sum can be included in your estate, allowing you to pass on wealth to your heirs.
Cons
- Longevity risk: With a lump sum, there’s a risk of outliving your funds, especially if not managed properly.
- Investment risk: Lump sum amounts are subject to market risks when invested.
- Tax implications: Large lump sum withdrawals could have significant tax implications.
Annuity Pros and Cons
When considering an annuity, it’s important to weigh the following pros and cons.
Pros
- Steady income stream: Annuities provide a consistent monthly income, which is a major plus for long-term financial planning.
- Longevity protection: The steady income you get with an annuity mitigates the risk of outliving your resources.
- Simplicity: Annuities offer a straightforward approach to retirement income without the need for active management.
Cons
- Inflation risk: Fixed annuities might not keep pace with inflation, potentially eroding your purchasing power over time.
- Less flexibility: Once you choose an annuity, you surrender the many options you have with a lump-sum payment, such as paying off a debt, investing the money or making an important purchase like a down payment on a home.
- Potential for lower returns: Depending on the annuity structure and market conditions, the total income received over time could be less than what you might have achieved with a lump-sum investment.
Final Take
Your decision regarding lump sum vs. annuity is one of the most important you will make from a financial standpoint, which means you need to weigh all of the factors carefully. The process includes taking stock of your current financial situation and future financial needs, along with your risk tolerance, retirement goals and desired lifestyle. If you are unsure of how best to proceed, consider consulting with a financial advisor to get a clearer picture of how each choice aligns with your long-term financial plan.
FAQ
Here are the answers to some of the most frequently asked questions regarding pension payouts.- What is a typical pension payout?
- A typical pension payout varies based on the pension plan, length of employment and salary. It can be a lump-sum payment or regular monthly annuities, calculated based on a percentage of the average salary and years of service.
- Are pension payouts guaranteed?
- Pension payouts, especially annuities, are typically guaranteed for life, providing a stable income in retirement. However, the guarantee depends on the financial health of the pension fund.
- Is it better to take a lump sum or monthly pension?
- Whether it's better to take a lump sum or monthly pension depends on individual financial needs, life expectancy, investment skills and tax implications. A lump sum offers flexibility and potential for growth, while a monthly pension provides a steady income.
- What is the 6% rule for lump sum pensions?
- When considering a lump sum pension payout, the 6% rule is a useful guideline. It suggests that if you can earn an annual return of 6% or more on your invested lump sum, it may outperform the regular payments from the annuity option over time.
Elizabeth Constantineau contributed to the reporting for this article.
The article above was refined via automated technology and then fine-tuned and verified for accuracy by a member of our editorial team.
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