Should I Take My Pension as an Annuity or a Lump Sum?
December 3, 2020Retirement Wealth
There's no one size fits all answer when it comes to deciding whether to take your pension as an annuity or a lump sum. Your best option will depend on many factors that must be evaluated simultaneously to determine your best path.
You've worked hard for the last 40 or so years and you're now ready to retire. You can't wait to kick back and enjoy the fruits of your labor in the form of your hard-earned savings. But before that, the quality of your retirement will be substantially affected by how you choose to receive your pension benefits. You are probably wondering: should I take my pension as an annuity or a lump sum? Well, this is a very serious decision and once you make it, you'll have to live with it for the rest of your life so you need to consider all your options and choose wisely.
The ideal solution for a majority of pensioners would be to split their pension, which is to take part of your pension as a lump sum and the rest as an annuity. This is advantageous in the sense that you can get the whole mix of investments using the lump sum and guaranteed monthly payments so that you can avoid falling on the wrong side of the two options. Unfortunately, not many companies offer this option and you may still be required to choose one of the options. As such, the best option for you will depend on various factors including your personal preferences, financial situation, and life expectancy.
And because this decision will affect your financial future in retirement, it's important to carefully consider all the options and factors involved and make an informed choice. In this article, we provide an overview of all the factors you need to consider to help you decide whether to take a lump sum or annuity payments.
Table of contents
Difference between a Lump Sum Payment and Annuity Payments
It's important to understand the difference between a lump sum payment and an annuity payment.
A lump-sum payment basically refers to a one-time payment of your pension benefits from your pension administrator. By choosing this option, you get a large sum of money and have the flexibility of spending or investing as you see fit.
Also known as regular or lifetime monthly pension payments; an annuity is a set monthly payment payable from your retirement date for the rest of your life. You can also choose for your spouse to continue getting these lifetime payments after your death.
Factors to Consider When Assessing Whether to Choose an Annuity or a Lump Sum
Choosing between an annuity and a lump sum payment can be quite overwhelming since there are many factors that you should consider. Each option has its unique terms and conditions but here are the factors that you need to consider.
Your Projected Life Expectancy
How old are you and how long do you expect to live? There are actuarial statistics that are usually used to determine the annuity payments. If you expect to live a long life and past these actuarial tables, then you can consider going for an annuity payment so that you do not risk outliving your pension. You, however, have to keep in mind that your annuity payments might be less valuable if you live a very long life. You may, therefore, have to adjust your cost of living to cushion yourself from inflation.
Is Your Pension Provider Stable Financially?
There have been instances where an employer or pension provider goes bankrupt and their retirees are faced with the unfortunate prospect of getting their pension benefits wiped out. Well, the Pension Benefits Guaranty Corporation (PBGC) is there to protect pensioners from such a scenario; it only guarantees a certain limit, which may be far much less than what you expected. If you aren't quite sure of your employer's financial stability and the ability to pay for your pension benefits for the rest of your life, then going with the lump sum option could make much sense.
Do You Have Other Sources of Income or are You Solely Depending on the Pension?
Having various financial sources gives you the freedom to take more risks with your investments. Even though you have to consider your living expenses, having other financial sources gives you the flexibility of either taking a lump sum and investing it or keeping it as an annuity and drawing more income from your other financial sources.
It wouldn't be wise to take a lump sum if your pension is your only primary source of income, especially if you're not good at investing. You may end up outliving the lump sum and that may not be so good.
Can You Skillfully Manage an Investment Portfolio?
We all know that pensions are professionally managed and you don't have to worry about managing such investments. All you have to do is sit back and enjoy the fixed monthly payments that they pay. As such, it can be a wise move to leave your pension in the hands of your pension administrators and get monthly annuity payments for the rest of your life, especially if you do not have the skillset of being a successful investor.
On the contrary, you can go for a lump sum if you believe in your investment skills and/or have a good financial advisor to help you through the process.
What if You Pre-Decease Your Spouse?
One of the main things to consider if you have a spouse who is also depending on your pension benefit is whether or not your annuity plan provides spousal coverage once you're gone. On the other hand, you should consider whether your spouse can manage your investments in your absence if you took a lump sum.
Annuity vs. Lump Sum
Let's look at how these two compare several factors.
Getting a pension in a lump sum is widely considered to offer more flexibility than an annuity. It gives you the freedom of spending and controlling the money as you see fit. It also allows you to increase your income but only if you invest wisely. On the contrary, it carries greater risks and you might outlive the amount if you don't manage it carefully.
While it lacks the flexibility that a lump sum can provide, an annuity offers certainty in retirement. The monthly payments are set in stone and you'll receive them unless your administrator goes bankrupt.
There are no guarantees that your lump sum will offer a steady and stable income for the rest of your life. You have to keep in mind that your investments are vulnerable to market performances, which are generally very volatile and there's a greater risk of losing all your money. Similarly, you can make unwise investment decisions or spend the lump sum money wastefully and you'll be faced with the dire consequences of outliving your pension benefits. In short, the longevity of the lump sum option is not guaranteed.
Differently, an annuity offers a guarantee that you'll receive monthly payments for the rest of your life. Simply put, its longevity is guaranteed and you don't have to worry about outliving your pension benefits. All you have to do is adjust your costs of living based on the inflation rates and you'll be good to go.
As far as taxes are concerned, there are no major differences between an annuity and a lump sum. As long as you've attained the age of 55, both pension plans allow you to withdraw not more than 25% of your pension benefits as a tax-free lump sum.
You, however, have to remember that a lump sum will be considered a taxable income when you withdraw it and income tax will be applicable on whatever further income you get from the investments made with the lump sum. The same does not apply to an annuity plan.
There are monthly income taxes on your annuity and are due every year. Although the pension administrator pays for this, it's paid from your pension pot.
The beneficiaries that you choose can inherit whatever money that was left in your lump sum pension plan without having to pay tax as long as you die before the age of 75. Again, any investment that you made from the lump sum can be a great source of your heir for many years to come provided that the investments are managed carefully and successfully.
The type of annuity that you choose will essentially determine whether your beneficiaries are paid after your death or not. For example, you'll only be the sole beneficiary of your annuity if you choose a single-life annuity plan. The main benefit of this is that the monthly payments will be a bit more. On the other hand, you can choose a joint-life annuity and nominate a spouse or a partner who will continue getting the payments on your behalf if they outlive you.
Choosing the Lump Sum Plan
The main benefit of taking a lump sum is that you'll have more control of your money and can choose to spend or invest it as you see fit. This option can be ideal for you if you want to invest and take advantage of the growth potential that investing brings. It can also be a great option if you aren't too much concerned about having a fixed and steady stream of income that can help you meet your daily living expenses in your retirement.
That's not all; a lump sum provides you with better financial stability. With a concrete strategy, you can invest this money and make it grow. Such investments can be passed to your beneficiaries once you're gone. As such, it can be an ideal option if you want to leave a financial legacy by leaving something for your children or even grandchildren to inherit. It can also be ideal if your health is poor and have a short life expectancy.
You, however, have to keep in mind that the main drawback of taking a lump sum is that there's no guarantee that your investments will pan out as you expect. There's the potential of losing money, especially in volatile markets and that can leave you with nothing. Again, there's no guarantee that you can handle a large sum of money without wasting it. It can be a recipe for overspending particularly if you aren't financially savvy. More importantly, the longer you live, the higher the chances of outliving the money, especially if your investments do not go as planned.
Choosing the Annuity Plan
One of the main benefits of choosing the annuity plan is that you are guaranteed monthly payments for the rest of your life. This can help you in budgeting for your living expenses and you won't have to worry about outliving your pension benefits. It can also be ideal if you choose a joint-life annuity as it gives you the option of nominating your spouse or partner to continue getting the benefits even after you die.
Better still, most annuity plans offer cost-of-living adjustments. This is essential in increasing your monthly payments by a given percentage to cushion you from rising inflations. This is not available if you choose a lump sum, which requires you to invest the money and protect yourself from inflation.
The most notable downside is that you don't have much say or control of your money as everything is planned and controlled by the pension administrator. You have to wait for the monthly payments and this can leave you in a precarious situation in case of an emergency.
The Ideal Option: Part Annuity, Part Lump Sum
With all the benefits and drawbacks of both plans, it makes a lot of sense to split your pension and take a portion of it as a lump sum and another portion in annuity payments. This mix is ideal as you can invest the lump sum and see how things pan out while still getting a given amount of guaranteed monthly payments.
You should, therefore, confirm with your pension administrator if they have this option. All in all, you should choose an option that best suits your retirement needs and financial situation.
About THE AUTHOR
With multiple family members currently in senior living facilities, David is in the trenches every week, learning the ins and outs of nursing homes, assisted living, memory care, and general senior living.Read more about David Bolton
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