Should I take a lump sum payout, or monthly income for life?

May 2, 2018

  • The choice between taking lifetime income or taking a lump-sum from your pension or structured settlement should come down to basic math, not emotion or a fancy sales pitch from a “rollover” expert.
  • In the case of a pension which you will rely on for your future income, taking the income is the lower risk strategy. You would need a relatively high rate of return on investing the lump-sum to give you the lifetime security of guaranteed income for life.

One of the most common questions financial planners get from recent or soon to be retirees is regarding lump sum payouts out of pensions. As rare as pensions are nowadays, I think this is still an important topic since for those who have pensions, the type of payout chosen will affect their finances for the rest of their lives.

In many government and union pensions, you are often given a choice upon retirement. Take the pension as lifetime income, which is what most people assume a pension is. Or, take a dramatically reduced income plus a large lump-sum payout. The tools used in this article could also be used to determine payout decisions for other situations such as payouts from private annuities, lawsuit awards, inheritances, or lottery or gambling winnings all of which generally offer a choice, a larger dollar value income payout, or a smaller dollar value up front payout.

So here is a scenario, a 65-year-old male is given a choice between a $500,000 lump sum payment, or $3,500 a month ($42,000 a year) guaranteed for life, with no death benefit.

Beware: If you ask a commission based financial planner for advice, how do you think he will answer? A $500,000 lump sum rollover into an IRA could easily generate a $25,000 commission if invested in an average 5% commission deferred annuity or $5,000 a year in a 1% annual renewal commission product. Why do you think so many financial planners advertise themselves as the “rollover specialists”? Rollovers are an extremely lucrative business.

How long am I going to live? Estimating the present value

A simple way to approach the lump-sum versus annuity decision is to calculate the cumulative amount that an annuity would provide.

Receive $42,000 a year and by the 12th year, or age 77, you will receive more than $500,000. If you live past 77, then the better decision is to take the income. If you plan to pass away prior to the 12th year, then it is better to take the lump sum and enjoy the money now. I would never assume death by age 77 though. The average life expectancy for a 65-year-old male is over 84, so taking the monthly pension would be considerably better. You would end up receiving $798,000 ($42,000 x 19 years).

But, the decision is not as easy as it first appears. For example, if you were to take the lump sum, and withdraw $42,000 in the first year, what happens to the remaining $458,000? Do you leave it in cash in your closet? If so, then the above calculation is correct and assuming death after age 83, the annuity would be the better choice. But if you were to invest the $458,000, it would grow and possibly leave you with a balance capable of lasting much longer than age 77.

Looking at the graphic above, if you were to take the lump sum and invest the unspent balance at 5%, your money would last until age 83. With life expectancy at age 84, and money running out in this case at age 82, I would lean toward taking the annuity.

The graphic assumes a hypothetical situation. Any descent financial advisor should be able to run these types of scenarios for you and put in a lot more detail than I have to really hone the calculations to your specific situation. The questions you need to ask yourself include:

How long am I going to live?

Realistically, if the answer is a fairly short period of time, take the lump sum and spend it. The problem is, no one really knows how long they are going to live. I recently discussed these scenarios with a soon to be retiree who was given less than a year to live, so the decision seemed obvious. Five and a half years later, she’s still alive. Modern medicine is amazing.

How will I handle investing if I take the lump-sum?

Where can you get 5% growth, consistently over a 20-year period, in today’s investment environment? There is no investment today that will guarantee 5% and anyone who says otherwise is trying to defraud you, so you will end up taking risk to try to get it, and you may win or you may end up running out of money.

So, I can’t really answer the question of lump-sum or annuity without looking at the specifics of your situation, but my goal above was to show you some basic numbers that you could, if you wanted to, replicate and help you to make your decision. My basic rule, though, is to take the least risky of all the options presented, which here would be to take the annuity, not the lump-sum.

What about taxes?

All income is taxed. A pension is deferred income, so it is still taxed as if you were working. With a lump-sum distribution, you should be allowed to roll over the funds into an IRA, preserving its deferred status and only paying taxes when you withdraw funds from the IRA. Therefore, I have ignored tax calculations above as the tax consequences would be the same for a lump-sum or annuity option. But, taxes could be a huge issue if you choose a lump-sum and then use the money to make a large purchase. Several hundred thousand in pension withdrawals could push you into the maximum Federal and State tax brackets, easily eating away up to half of the proceeds depending on which State you are in.

Can I trust the pension company?

I have dealt with many retirees over the years who don’t care about making the right decision from a financial perspective, they have other motivations. They choose to take the lump-sum and complete an IRA rollover because they want control of the funds and don’t trust the organization making the monthly payouts (i.e. State government or pension corporation). According to Bloomberg, in 2016, State pensions were underfunded by $1.1 trillion. That is a huge liability that, as a nation, we have no idea how we are going to cover those future liabilities. Since 1974, pension do pay premiums into the Pension Benefit Guarantee Corporation, a US Government run insurance plan that covers bankrupt pensions, but you need to decide for yourself if you trust the government to take care of you over the next many decades, or do you want to be in control?

What about a death benefit?

As stated above, if you are planning to live a very short time after retirement, by taking a pure annuity, you will be losing a lot of money that could be left to your heirs. If you are trying to protect your spouse, you can still consider an annuity, but you should look at the survivor benefit options. Additionally, if you do choose the annuity because you are healthy and plan to live a long time, considering using some of the monthly income to purchase a life insurance policy to provide a death benefit to your non-spouse heirs. This strategy is typically referred to as Pension Max, and can work to give you the best monthly pension while still providing for your heirs.