Should I Take a Lump Sum or Annuity from My Pension or Retirement Package?

A Critical Decision: Lump Sum or Annuity

We are seeing more clients and friends making major financial decisions around early retirement and severance packages, particularly as companies reduce workforces due to the COVID-19 downturn. Generally, the decision is between a one-time lump sum distribution or an ongoing annuity payment from their pension or “package.”

This critical decision can be quite complex as there are many factors to consider. While each “package” has unique terms and conditions, the financial analysis generally requires one to consider: age, longevity, cost of living, inflation expectations, cost of living adjustments, Social Security benefits, ancillary benefits such as spousal or survivor benefits, other investments and your own investment discipline/skill. Most of these factors are interactive – meaning they must be evaluated simultaneously to determine your best path.

Key Questions to Consider as You Assess Your Separation or Retirement Package

1. How old are you and how long do you expect to live? And, are there cost of living adjustments?

There is an interesting trade-off here. If you expect to live a long life - well past the actuarial tables that are used to determine annuity payments - then you would be inclined to keep the annuity to reduce “longevity risk” (that is, the risk of outliving your money). However, the longer you live, the less valuable those payments might be. Unless the payments adjust for cost of living increases from inflation, the real value will decline. Since most annuities do not do this, you are left exposed to “inflation risk.”

2. If you have a pension, how big is your expected annual benefit and how stable is the provider?

While the Pension Benefits Guaranty Corporation (“PBGC”) “guarantees” a pension, this is true only to a certain limit (about $5600/month in 2020), and typically their guarantee does not include any cost of living adjustments. In the event of a PBGC takeover, payments in excess of the PBGC maximum are subject to company discretion and its ability to pay. If you have a large pension balance, that could entail a significant amount of single investment risk since the entire balance may not be covered. A pension plan funding rate of less than 80% should be considered a red flag.

3. What is your total net worth and how much of your net worth is in the annuity and/or lump sum?

The more financial resources you have, the more risk you can likely take with your investments (although you must also consider living expenses - discussed in the next point). Should you keep the annuity and view it as a fixed-income alternative? Or, can you more efficiently access fixed income elsewhere?  Annuities tend to be less essential (as guaranteed income) when you have more resources. And, don’t forget Social Security is a fixed income source as well.

Finally, for those above or near “accredited investor” or “qualified purchaser status,” a lump sum payout may provide more opportunities for private investments, which may allow for better diversification and the pursuit of the “illiquidity” and “control” premiums.

4. What is your expected living expense post-retirement and how much of this expense is covered by the annuity?

If your pension will be your primary source of income AND is necessary to meet your living expenses, then you would likely lean toward taking the annuity option in order to gain some level of comfort that your expenses will be covered. However, since living expenses will likely increase over time due to inflation, it is important to have some assets that will also increase accordingly. Social Security benefits offer a COLA component, which can help reduce inflation risk.

On the other hand, lump-sum distributions may offer you more options for investing, charitable giving, tax management, and estate planning (see below) if you do not need the pension to cover all or most of your living expenses.

5. What are the tax consequences of your pension or severance lump sum?

Annuities payout over time, so any post-tax cash flow analysis needs to consider long-term tax rates inclusive of all expected income. If your lump sum can be rolled over into a qualified plan or Individual Retirement Account, then this may be more tax-efficient over the long run depending on your age and required minimum distributions. If a lump sum is taxed upon distribution, you must look at net cash received (after any tax planning) and after-tax cash flow over time. Be sure to watch out for any penalties!

6. How skilled of an investor are you and/or can you access good advice? How will the annuity fit in your overall portfolio?

Pensions are professionally managed, so you don’t have to worry about managing these investments. They just provide fixed payments. For most investors, it may be wise to leave the money in the pension provider’s hands. However, if you are a savvy investor and/or can engage a good advisor, then you may be better off taking a lump sum so you can tailor the investment strategy specifically to your overall investment, cash, tax, and generational planning needs.

7. How much tax management do you want to have? What are your charitable goals?

With an annuity, you have less control over both these opportunities. With a lump sum, you have a greater ability to manage income around your investments and manage taxes (e.g. Roth conversions) and charitable giving around your opportunities. Of course, this also depends on your other resources.

8. What happens when you pre-decease your spouse? How much do you want to leave behind?

Does the annuity plan provide for spousal coverage? Is there a survivor benefit? What does it cost in annual payments to get this benefit? If you took a lump sum, how would your investments be managed in your absence? For those packages that offer survivorship benefits, these should be assessed against self-insurance, the cost of third-party coverage and the cost of taking this option in the package.

9. What other benefits are available to you as retire and how valuable are these?

Are there healthcare benefits? How do these benefits supplement or replace Medicare? Does your spouse also receive these benefits? What about dependents, if any, particularly if there are special needs? What about other benefits, such as dental, vision, travel, legal or financial planning? Will these really be used and how valuable are they?

We Can Help!

As you can see, choosing between a lump sum or annuity is a difficult decision that requires in-depth analysis and planning. There are many unknowns so reviewing different assumptions and outcomes can help you make a more informed and confident decision.

Kings Path provides clients with financial and retirement planning services. If you would like to schedule a free consultation, please reach out at service@kingspath.com.