Pension Planning: Lump Sum or an Annuity?

Apr 18, 2016


MoneyLife100If your company’s defined benefit pension offers either a lump sum payout option or various annuity options, which option should you choose?

The Pennsylvania Institute of Certified Public Accountants offers some general advice to help you determine which option may be best for you and your family.

Your Financial Needs

It is customary that basic expenses be covered by guaranteed sources of income. For example, will Social Security be enough to cover your housing, utilities, food, and health care costs? How much additional guaranteed income will you need? Therefore, first list all investments, sources of income, and debts.  

Compare the pension annuity estimates to what you could get for the lump sum in the open market. With interest rates at historic lows and defined benefit pension plans such as the State Employees Retirement System and the Public School Employees Retirement Systems using contractually agreed upon interest rates, these plans’ pension number are generally much more favorable. Keep in mind that the risk of providing you and potentially a spouse with lifelong income is placed on the plan. If you rollover the money, the risk is shifted to you.

If you have guaranteed income already in place to cover your necessities, you may want to consider the lump sum option for additional growth opportunities and flexibility in retirement. You could allow the lump sum to grow to offset inflation risk. You could use the lump sum for IRA-to-Roth conversions (filling up the lower tax brackets). The lump sum also could provide the flexibility of travelling or covering the “wants” (not “needs”) of your retirement budget.

The Longevity Factor

When do you expect to die? Though it sounds morbid, it is very important to have an idea of when you think you will die and why. Annuity options are based on average life expectancy or joint life expectancy. But this decision is based on you. If you really feel that both you and a spouse will not live close to life expectancy (and you have personal health history that indicates such), then perhaps a lifelong annuity is not the choice for you. As long as one person is expected to reach the average life expectancy, the annuity option should be considered.

Consider Inflation

One drawback of an annuity payment is that pensions are rarely indexed for inflation. With medical costs being a major concern among retirees, and these costs escalating rapidly, this is a major consideration. At an annual 2 percent inflation rate, the purchasing power of a $2,000 monthly check would  be worth only $1,640  in 10 years and $1,346  in 20 years. Social Security is indexed for inflation. What other assets do you have to offset the risk of living too long and having your purchasing power eroded by inflation?

Consider Investment Risk

With better potential return comes higher potential risk! What if your portfolio doesn’t perform as you wish? Will you have the discipline to forgo purchases until the market comes back up? Money you reasonably expect to spend in the next three to five years shouldn’t be at risk.

Think of Your Heirs

A company’s annuity pension benefits generally cease upon the death of the worker and/or spouse. Other assets or life insurance will have to be used to pass assets on to heirs at your death. Again, guaranteed income is needed to cover your retirement needs. Any wants and desires should be covered by discretionary income. Your priority needs to be having a safe and secure retirement. Only after that is determined can you focus on helping children and grandchildren if you want.

Consider Taxation

Run the numbers. Estimate your marginal and effective tax rates. You will owe federal income tax on every monthly pension payment. A lump sum being rolled into an IRA would defer the tax until you take the money out. You are required to start taking distribution at 70 ½, when minimum required distributions take effect. You can also use the lump sum for IRA-to-Roth conversion if you have “space” in the lower tax brackets. It will depend on your specific situation.

Final Piece of Advice

A CPA or certified financial planner is the best person to help you with this important decision. That adviser should be someone who can run the investment numbers and show you the tax implications over time. Make sure that adviser takes the time to sit down and educate you on all the different ramifications so you can make the best decision about how you cash out your pension. Don’t have a CPA? Visit www.picpa.org/moneyandlife to use the CPA locator tool.
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Disclaimer:
The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.