Pension annuity vs. lump sum: How to decide
We are seeing more situations where our clients who are close to retiring from large companies such as GE, National Grid, Golub and Verizon are being offered early retirement packages to incentivize them to leave a few years earlier than they expected. These packages frequently offer an option to take a lump sum from their pension instead of receiving a monthly annuity paid out over their life time. Beyond the question on whether they should take the early retirement package, understanding whether to take the lump sum distribution versus the annuity is a significant decision with longterm impacts and the answer is not often black and white. As we provide guidance on the best way to approach this decision, there are several criteria we use as our primary decision points.
Control – This is one of the biggest factors to consider. Would you rather have control over the assets and take distributions as needed or does it give you more comfort to leave that control with the company? If you choose the lump sum, you need to have a plan on how the assets will be invested and what level of distribution is sustainable. On the other hand, if you take the pension annuity, you need to feel comfortable that the company is going to be in good financial health for the next 20-30 years. If the company goes out of business, a federal agency known as the Pension Benefit Guaranty Corporation (PBGC) would most likely take over providing the pension payments but at a reduced level.
Inflation – Most pensions don’t increase their pension annuity over time for inflation. This may not sound that important when you first retire but as prices continue to increase every year, especially healthcare costs, it can become difficult for retirees to continue covering their rising expenses when their income is not growing.
Withdrawal rate – With any financial decision it is important to complete an analysis to understand how the options compare to each other using different assumptions. For this decision, there are several ways to perform such an analysis but a simplistic option is to compare the effective distribution rate that you would need to receive from the lump sum amount to have it be equivalent to the monthly pension. If the pension distribution rate is greater than 7.5% annually then it becomes more compelling to take the annuity since it would be difficult to distribute cash at this level from a balanced portfolio. If the distribution rate is less than that amount, then the lump sum option becomes more attractive.
Personal Situation – Any personal factors must be taken into consideration when making a decision of this magnitude. For example, if you have any serious health issues or anticipate large cash needs in the future, taking the lump sum would be a better option. If you have no heirs and you are not concerned about leaving a financial legacy, you might favor the annuity option. An important point to remember with the lump sum option is that in order to preserve the tax deferred nature of the lump sum in place, you must roll it into an IRA until you need to take distributions. If you fail to do this, and just take the lump sum as a cash distribution, the full amount will be taxable. As with any major decision, it is important to map out each decision point and to get the insight of a financial expert as well as others who have had to make this type of decision in the past. Taking the time to make sure you are well informed will prove to be beneficial in the long run. Marty Shields, CFP, CPA is Vice-President of Bouchey Financial Group, Ltd. with offices in Saratoga Springs and historic Downtown Troy. E-mail investment and financial planning questions to planningpaysoff@bouchey.com. Information contained in this column should not be considered as the receipt of personalized financial advice and please consult with your financial adviser.