People who retire from companies are often given the choice of turning their accumulated pension benefits into a lifetime income stream or cashing the pension in and receiving a lump sum. The income stream takes the form of an annuity and offers retirees predictable income. The lump sum option provides retirees with complete control of their finances. The overall financial situation of a retiree dictates which plan works best.
Actuaries at insurance firms estimate how long employees typically live and use those estimates to determine the level of monthly annuity payments. If the estimates are too conservative, the fund runs out of money before the annuitant dies and the insurance company must cover the shortfall. If payments are too low, no one will opt to buy the contracts. Crucially, company pension plans use gender-neutral mortality tables, which means they assume men and women live to the same age, even though statistically women live longer. Therefore annuity payouts are more attractive for men than women.
People who choose to receive a lump sum can invest the money in practically anything and this freedom of choice appeals to lots of retirees. Conservative investments like certificates of deposits and bonds offer steady income and stability. Stocks and mutual funds enable investors to pursue higher levels of return, but with the chance of greater rewards come greater levels of risk. People who are not reliant on pension funds to cover day-to-day costs can use the funds to make big purchases like homes or cars. People cannot make big purchases with funds tied up in annuities.
Annuities expose investors to two main risks: the risk of the insurance company going bankrupt and inflation risk. Annuties payments are reliant upon the continued financial strength of the insurer and could cease if the insurer goes bankrupt. Additionally, most pension plans do not increase annually to counteract inflation and the annuitants spending power erodes over time.
People who take lump sums must manage the money themselves and attempt to grow it at a faster rate than they spend it. Mutual funds and other investments are not federally insured. Bank products are but historically do not keep pace with inflation.
Many financial planners recommend that instead of choosing between a lump sum and an annuity that investors should split their money between the two. You can roll the pension into an Individual Retirement Account and use some of that money to buy an immediate-income annuity that works in the same way as a pension annuity. Invest the remaining funds in a variety of investments and attempt to grow those funds. The non-annuity funds are accessible for people who have unexpected emergencies.