Should You Take an Annuity or a Lump Sum?

Almost every retiree has a choice of how to receive benefits: as either a lump sum or a stream of annuity payments. The choice is critical, yet it doesn’t receive the critical analysis it should.

About half of employers give these options on 401(k) and other retirement plans. You face a similar choice with an IRA. You can manage the account or you can purchase an annuity with all or part of it.

Once an annuity is selected, the decision cannot be reversed without a penalty. Select a lump sum and an annuity can be purchased later with the account balance.

Here are the factors to consider when making this choice.

A lump sum has the potential to earn a higher return and increase net worth or make the money last longer. Many people who take lump sums do so for this reason.

Before choosing a lump sum, consider how you would invest it and what the likely rate of return will be. Then, estimate how long the account will last after spending and taxes.

A problem in the 1990s was that many people were over-estimated the long-term returns they could earn. Many invested very aggressively to earn the estimated returns. Instead, the bear market caused a sharp reduction in their accounts.

To avoid big problems, you should make conservative estimates. Choose a reasonable estimated rate of return. Carefully estimate your spending and adjust it for inflation each year. Then, take a look at what would happen if you earned only 1% or 2% less each year.

Don’t underestimate life expectancy. The fastest-growing age group is ages 90 and older. Most of us will have to make our money last longer than our parents did.

After making estimates for the lump sum, compare it with an annuity.

First you have to select the type of annuity payment you would want. An annuity could pay for your life or for the joint life of you and a beneficiary (such as your spouse). Or an annuity could make payments for a fixed term of years. Some annuities will pay for either life or a period of years, whichever is longer. Once you select an option, the employer will tell you what the annual or monthly payments would be.

The big advantage of an annuity is that it is guaranteed to last for the selected payment period. You cannot outlive a life annuity.

There are disadvantages. Most annuity payments are fixed, meaning that they will lose purchasing power to inflation each year. An annuity also leaves nothing for your estate. You can have payments to continue to a beneficiary if you take lower lifetime payments.

The payments from an annuity are based on a yield close to that of intermediate bonds. With a lump sum you might earn a higher return.

The security of an employer annuity depends on the financial health of the employer and its pension fund. The annuity might be guaranteed by the Pension Benefit Guaranty Corporation, though there is an annual limit of about $44,000 (indexed for inflation) on the guarantee. An insured annuity depends on the insurer’s stability.

Many prospective retirees miss one important step. After getting your employer’s annuity quote, compare it with commercial annuities. Each employer and insurance company uses its own interest rate and expenses to calculate annuity payments. When an employer offers an early retirement incentive, the annuity might be subsidized. Otherwise, insurers might make higher annuity payments. I’ve found that payouts among top-rated insurers vary by up to 20%. That is a 20% difference in your annual income for life. Don’t settle for the first annuity you are quoted.

An insurer also might allow partial withdrawals of up to 10% of the balance in the case of emergency spending needs. An employer annuity might not offer this feature.

Now, you have all the information needed to make a decision. With an annuity, you probably have to live on less than the annual payout and invest the rest for the future. With a lump sum, you have to manage the investments and spending to make the money last.

Health, family history, and heirs are other considerations. If a less-than-average life span is a probability, you might take a lump sum to ensure the benefit goes to heirs or charity instead of an insurer or retirement plan. Some people will select a lump sum just to increase the odds that their heirs get something.

Of course, you might take both options. You could take a lump sum and buy an annuity with part of it.

Perhaps the best strategy is to take the lump sum now and buy an immediate annuity later. The advantage is that when you are older the annuity payments will be higher than they would be today. This strategy also gives you the opportunity to build up the fund a bit through investing and careful spending. You do take the risk that the fund will be diminished through low investment returns or high spending.

Another reason to wait before choosing an annuity is that interest rates are very low these days. They might rise over the next few years, and higher rates would increase payments from new annuities.

This article shows you how to gather and analyze the data to make this choice. The issue boils down to: Which risks do you want to take? A lump sum carries the risk that you will earn low investment returns or overspend. An annuity carries the risks that inflation will significantly reduce its purchasing power over time and that you could have earned better returns with a lump sum.