Pension: Lump Sum Vs. Annuity

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Retirement income usually comes in the form of either a pension or an annuity. In the case of a pension, you may have a choice. Some pensions allow you to manage your own retirement savings. If your pension gives you the option, you have to make a choice between receiving a lump sum or annuity payments.

Types

  • A lump sum distribution of your retirement savings means that the pension gives you a check for the balance of your total pension amount or deposits this amount into your bank account. If you elect to receive payments, the pension administrator will send you monthly payments via an annuity. These payments will extend for your lifetime or for a set period of time.

Significance

  • The significance of receiving annuity payments is that the insurance company is managing your pension for you. The insurer invests the money into income producing assets to provide a consistent monthly payment to you. With a lump-sum distribution, you are responsible for investing your own pension. You may invest your retirement savings into any investments you wish.

Benefit

  • The benefit of having the insurance company make annuity payments to you is that you don't have to worry about managing your own retirement. Since it's impossible to predict your date of death, the insurer takes the risk that you will outlive your total pension. With a lump-sum distribution, you get full control over your retirement savings.

Disadvantage

  • The disadvantage to annuity payments from the insurer is that you are stuck with what the insurance company gives you. If you need more than the monthly payment, you don't have access to a large lump-sum of money. The disadvantage to a lump sum payment is that if you're not an experienced investor, and you lose money in your investments, then you could end up with far less than what you expected in your retirement. Also, you run the risk of running out of money during your retirement.

Considerations

  • When deciding whether to take a lump-sum of money or take annuity payments, consider whether you think you can manage your own investments better than an insurance company can. As a compromise, you may consider taking a lump sum distribution and then purchase an annuity with some of your retirement savings while investing the rest. In this way, you can guarantee yourself some kind of income for your lifetime.

References

  • "The Calculus Of Retirement Income"; Moshe A. Milevsky; Cambridge University Press; 2006
  • "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
  • IRS: Publication 575
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