It's a common lament that old- fashioned defined-benefit pensions—the kind that pay a guaranteed monthly income for life—are rare nowadays. And for public-sector employees they might become even more scarce as states slash spending to close budget deficits. So why do roughly seven of 10 employees who still have such pensions pass up those monthly checks and opt for a lump-sum instead when offered a choice?
We can only speculate on people's reasons, but we do know something about who's likely to do what. For example, younger and wealthier pension-plan participants are more likely to take a lump sum. Men and married employees prefer them too, while women favor monthly pension checks.
Both options have advantages and disadvantages. When you take your pension as a monthly annuity, you gain longevity insurance. Your check will arrive each month until you die, and you also have the option of spreading the payments over your spouse's lifetime (for more information, see Pick the right annuity).
On the downside, your monthly check will lose purchasing power over the years because most private-sector pensions are not adjusted for inflation. Of course, you'll have to pay taxes on your payouts. You'll also have to bear the risk that your employer will fail to pay the benefits it promised. If it hits hard times and terminates its defined-benefit plan, the federal Pension Benefit Guaranty Corporation in many instances will step in to take over its obligations. The agency guarantees that you'll receive the benefits you've earned, up to certain limits. The maximum amount is set each year by law. (To check current limits, go to www.pbgc.gov and search for "maximum monthly guarantee tables.")
By contrast, you can invest a lump sum for growth so that your retirement income keeps pace with inflation. If you roll over a lump sum into an Individual Retirement Account, you won't have to pay taxes on the money until you begin withdrawals. In addition, you'll retain a stash of cash that you can tap in case of emergency. After you die, your heirs can inherit what's left of it.
The big hitch is that you shoulder all of the risk of managing your money in the years ahead. You'll also incur investment costs, such as mutual-fund fees. Your expenses will be even greater if you hire a financial adviser to manage your money. And spend too much of your lump sum too soon or rack up disappointing investment results, and you could run out of money.
If you have a pension and can choose between an annuity and lump sum, don't get hung up trying to calculate which option will pay you more over your lifetime. To determine that, you would need to know two unknowable things: how long you'll live and how much your investments, if you go the lump-sum route, will earn. It makes more sense to focus on your pension in the context of your overall financial plan. "What it really comes down to is figuring out what you want to accomplish with the money," says Alan Glickstein, a senior retirement consultant with Towers Watson, benefits consultants in Dallas.
Start by asking yourself two questions:
To determine whether you should annuitize your pension benefits to help pay your recurring bills, draw up an estimate of your postretirement expenses. Last month's Retirement Guy column provides some guidance on how to do that. Also get an estimate of the Social Security benefits you'll collect by going to www.ssa.gov. Social Security is like a private pension only sweeter because it's indexed for inflation. If Social Security will cover all or most of your bills, you might not need or want another annuity.
If Social Security doesn't come close to covering your expenses, it might make sense to take your pension as an annuity. But think twice if you have little or no additional assets. If you annuitize your pension, you won't have any liquid assets to pay for extraordinary expenses like major home repairs or nursing care.
You can ask your pension plan's administrator if you can annuitize part of your benefit and take the rest in a lump sum, but most plans don't offer that option. Or you can take all of the money in a lump sum, use part of it to buy an immediate income annuity from an insurance company and keep the rest in investments you control.
If you're fortunate enough to have a 401(k) plan as well as a pension, you might take your pension as an annuity and use the money in your 401(k) for emergencies. Most 401(k)s offer only lump-sum payouts, which you can then roll over into an IRA.
Federal law assumes that your spouse will need to continue receiving monthly checks from your pension after you die. So a joint-and-survivor annuity, which covers your lifetime and the lifetime of your spouse, is the default option on most plans unless your spouse agrees in writing to waive it. It pays less than a single-life annuity because it is expected to pay out for a longer time.
Two-career couples might not need the protection this law offers. For instance, if your spouse also earned a decent pension, each of you might prefer to take single-life annuities. Or you might choose a joint-and-survivor annuity while your spouse takes a lump sum.
Steer clear of so-called pension-maximization plans promoted by insurance agents. In this scheme, you take your pension as a single-life annuity for its higher payout and buy a life-insurance policy. If you die first, your spouse invests the proceeds. The net income you both collect is supposed to be greater than the amount you would have received with a joint-and-survivor pension, even after paying for the insurance policy with after-tax dollars. But such plans can easily fall apart. You might not be able to afford an insurance policy that's large enough. Or you might pay hefty premiums for years, then let it lapse because you can no longer afford it.
Pension plans differ, but you'll probably be able to choose among three basic types of annuities:
This article appeared in Consumer Reports Money Adviser.