Lump sum vs pension
At some point, many investors are confronted with the choice between a lump sum payout or a defined benefit pension. This article is intended to help you make such a decision. There are many factors to consider, and for each person the choice is personal, and depends on their circumstances.
A defined benefit pension plan provides a stream of income that is paid for the remainder of your life. There may be a survivor benefit that pays some percentage to a surviving spouse. On the death of both spouses, payments cease, and there is no residual value.
A defined benefit pension plan is essentially the same thing as a simple annuity. You can use your own money (lump sum) to purchase a single premium immediate annuity (SPIA) which, in its simplest form, pays you an income for the rest of your life. When you die, the payments stop and there is no residual value. SPIAs can have survivor benefits. A single premium deferred annuity (SPDA) involves purchase with a lump sum now, but with payments to begin at some future date. If you die before payments begin, there is no benefit.
There are many, many variations and additions to these options. For example, term certain provisions guarantee payments for some period, whether death intervenes or not. Others guarantee at least payment of the original lump sum used to purchase an annuity.
Pensions and annuities differ in how they are regulated and how they are taxed, particularly by the States. Also, they have different guarantee systems against bankruptcy or failure of the provider.
A stream of payments that increases with inflation is said to be “real”. If the dollar payment amount is fixed, it is said to be “nominal”. Many government pensions are real, indexed for inflation. In the private sector, pensions are usually nominal, with no inflation adjustment. Social Security (SS) payments are indexed for inflation.
Annuities may be purchased as real or nominal, or even with a fixed yearly increase that does not depend on inflation. Deferred annuities may have inflation protection that begins only after payments start, with no protection during the waiting period.
Inflation protection is expensive to purchase, and it cannot be leveraged. Your investments in TIPS (or gold, or whatever) do not protect your other assets against inflation. For pension or annuity income, a “ladder” might be a good idea. Let’s say a $100,000 investment will, today, pay $4,000 real or $7,000 nominal per year. Well, a choice might be to pay 4/7, or $51,000, to get $4,000 of nominal income and invest the remaining $49,000. In a few years, buy another nominal annuity to compensate for actual inflation. Of course, you will also be assuming the risk of interest rate changes in the price of annuities, but you will also have a much better idea of your actual spending needs.
- On retirement, employee has a choice of a pension (“annuitization”) or a lump sum, or a mix of both. Such a choice is common in public sector pensions in the USA. The choice is often “fair”. (See below.)
- After retirement, a retiree is given a choice to take a lump sum instead of their existing pension. Such offers are now common in private industry. They are usually not “fair”.
- An ex-employee is offered a lump sum now or a pension at some future retirement age. Such offers are usually fair, but often not significant in the total picture.
- Delay Social Security. Delaying one’s claim on Social Security is the same as purchasing a real annuity with joint survivorship. For most people, this is an exceedingly good deal.[note 1]
- Buy an annuity. If you have a lump sum, you can buy an annuity of your choice. This is not very different from being presented with the either / or choices above.
Do you have a “fair” choice?
The question of a fair choice is, “Will my lump sum buy my offered pension or annuity?”
Private companies that offer pension buyouts use a mandated formula that has little to do with the market value of the pension or annuity. These are generally not fair deals. Often, the lump sum falls 50% short of the market amount needed to buy the pension.
The first step is to evaluate the extent to which you have a fair choice. Are your lump sum and pension / annuity choices interchangeable in terms of value?
As of July 2020, for a 65-year old male, a nominal annuity will pay about 5.9% with no survivor benefit. In other words, $100,000 in an annuity will pay back about $5,900 per year, for life, according to ImmediateAnnuities.com. This is not the same as earning 5.9% on an investment. With an investment, one gets the earnings and the initial investment. With an annuity, the initial investment is gone and one receives only the annual benefits.
A real annuity (which is hard to find) will pay back less than a comparable nominal annuity to start, then increase according to some formula. To evaluate taking or delaying Social Security, consider Open Social Security: Free, Open-Source Social Security Calculator. That calculator is particularly useful for couples, but can also evaluate choices for a single.
When evaluating your options be careful to ensure that you are considering the same factors such as age, sex, and single or joint survivor benefits when comparing your possible pension and annuity choices.
If one wishes to use assumptions on longevity or investment return different from actuarial or mandated formulas, spreadsheet calculations can be done. For examples, see
- Three ways to evaluate "pension now" vs. "pension later", or
- Comparison of immediate Lump Sum pension vs. immediate annual payments (including COLA option)
on the 'Misc. calcs' tab of The MMM Case Study Spreadsheet. Another good approach is shown in Another Pension Lump Sum Help Needed.
What am I choosing?
A pension or simple annuity is an income stream for life. You get the income no matter how long you live, but after you die there is nothing.
The lump sum is just that. You get it now, and it’s up to you to manage it for the rest of your life.
It is very important to understand that a pension or annuity is an insurance product. It pays a good benefit because you may die early. If you live longer, you get paid the good benefit because others have died earlier than you.
For a 65-year old in the USA, life expectancy is about age 83. If you die before that age, it is too bad for you. If you live longer, you are benefiting from the fact that others of your cohort have died before you. A pension or annuity provides “mortality credits” or insurance against living a long life. Such insurance is almost impossible to obtain in any other way. This basic idea is exploited by a “Tontine”.   Some people worry that if they choose an annuity, they may die before they get their money back. Well yes, that is exactly how it is supposed to work. Those who live longer benefit from payments that would have gone to those who died earlier.
This concern is addressed by annuities that have a term certain or some other form of minimum payment guarantee. They may guarantee payments for some term of years, or guarantee to return your original purchase amount. Note that this is done by adding some amount of term life insurance to your annuity. So, you have supplemented your insurance against living a long time with insurance against living a shorter time.
Choosing the pension at retirement is a choice that cannot be changed. However, taking the lump sum does not preclude buying an SPIA later so in this sense the lump sum is more "flexible". The lump sum is also more flexible in terms of choosing your interest rate for long term annuitization. For example, given current low interest rates, you may choose to delay purchasing an annuity for a few years.
The lump sum choice requires having the discipline to manage it for 30 years or more. It is a fact that many windfall recipients mismanage their wealth and end up in worse financial condition than before the windfall.
Taxes and fees are also considerations. Pensions are usually taxed as ordinary income, while the capital gains and dividends from an invested lump sum may be taxed at lower rates. Personal strategies to delay a claim on Social Security or to convert traditional IRAs to Roths also come into play.
If you have a pension, there is a risk that the providing company or government unit may fail to provide the expected benefit. Public pensions are often not insured or guaranteed, and are often under-funded although benefits are protected to varying degrees by law. Private pensions are often insured by the PBGC, though certain executive pension perks are not. Your benefit from the PBGC depends on your age when the company plan fails, not your age at retirement. If you are younger than age 65, there may be a significant penalty. (Some companies provide incentives for retirement at age 62 or earlier that are not covered by the PBGC.)
If you have an annuity, there is a risk that the providing insurance company may fail. Annuities are guaranteed by the insurance industry according to laws that vary by each State. They are not guaranteed by the States, and the amount of the guarantee is quite low. (What is guaranteed is the current net present value of the annuity, with limits in the low six figures.)
If you take the lump sum, you become the provider. This represents a huge transfer of risk from the plan sponsor to the individual (the risk of pension failure is miniscule in comparison). A prudent investor considering taking his pension as a lump sum should acknowledge the risk of investing on his own before making any other decisions.
A framework for a decision
Many advisors suggest that, in retirement, you should seek to assure an income stream that meets your minimum needs. See Zwecher, Bernstein, and Otar. Obviously, a pension or annuity can contribute to that income stream.
As suggested above, the best way to buy an income stream is to delay your claim on Social Security. If the lump sum will enable you to delay that SS claim, consider taking it. You may have other pensions that do not have a lump sum option that will contribute to your retirement income.
If you then still need retirement income, you must consider whether to take the offered pension or annuity, or whether you believe you can do “better” with the lump sum by yourself. There’s the rub.
Step by step
- Is your offer a fair deal? In other words, can your offered lump sum buy the pension?
- Have you considered delaying your claim on Social Security, and how might this lump sum enable you to do so?
- What is your opinion on your own mortality? Do you want to plan beyond a life expectancy of 83 years?
- What do you think of the viability of the provider, be it your company for your pension, your insurer for your annuity, or the Federal Government for Social Security?
- Have you considered and planned for the income streams you will need in retirement?
- Do you think you can do better with a lump sum by investing it yourself? Better than a guaranteed income stream for the rest of your life?
- If you delay starting your retirement or old-age benefit past FRA (Full Retirement Age), you earn Delayed Retirement Credits and get a larger benefit. Wife, husband, widow, and widower benefits are also reduced if started before FRA (using different formulas), but are not increased by waiting past FRA to start. See this IRS table for insight: Early or delayed retirement. Also see: Planning Social Security benefits.
- Vanguard Annuity Access
- Tontine, wikipedia
- Moshe Milevsky on Tontines , Wade Pfau blog
- Legal Constraints on Changes in State and Local Pensions
- General FAQ's about the PBGC, The Pension Benefit Guaranty Corporation
- State Guarantee Funds, liability limits, annuityadvantage.com.
- What Happens When an Insurance Company Fails?, National Organization of Life & Health Insurance Guaranty Associations
- Michael J. Zwecher, "Retirement Portfolios", Wiley (2010) ISBN 978-0-470-55681-8
- William J, Bernstein, "The Ages of the Investor: A Critical Look at Life-cycle Investing"CreateSpace (2012) ISBN 1478227133
- Jim C. Otar, "Unveiling the Retirement Myth", self-published (2009) ISBN 978-0968963425
- Moshe A. Milevsky, Thomas S. Salisbury, Optimal Retirement Tontines for the 21st Century: With Reference to Mortality Derivatives in 1693
- Should You Take Your Pension in One Lump Sum?, by Jane Bryant Quinn, AARP Bulletin, August 20, 2012 (via ImmediateAnnuities.com).
- SEC.gov | Lump Sum Payouts: Questions You Should Ask Yourself Before You Invest a Dime