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Choosing a Retirement Benefit: Pension Annuity vs. Lump Sum

Choosing a Retirement Benefit: Pension Annuity vs. Lump Sum

September 12, 2023

 The election of a retirement benefit should be informed by a comprehensive analysis of your unique situation and priorities.  Though many ascribe an indelible value to the ‘peace of mind’ provided by ‘guaranteed income’ it often comes at a hidden cost that can compromise the security of your financial plan.

The benefit election decision cannot be reversed which amplifies the stakes of making a poor decision.  An objective and quantitatively defined selection process offers a clearer picture of the relative risks and tradeoffs entailed in your retirement benefit options. 


Start with the details


Cost-of-Living Adjustment (COLA)

Determine whether the annuity option entitles you to receive annual COLAs.

Perhaps the most significant and commonly overlooked consideration of those innately attracted to the annuity option is the COLA- or rather the potential lack thereof. If your pension annuity does not receive annual cost-of-living adjustments that are greater than or equal to the rate of inflation your benefit is shrinking year by year in real terms.  ‘Guaranteed income for life’ without a COLA does not promise to sustain you and your lifestyle, simply to deliver a monthly check of the same numerical value until you and/or your spouse die.


Determine and quantify what (if any) are the survivorship options and benefit amounts of the annuity option. 

Most pensions offer several monthly benefit amounts based upon the survivorship terms- i.e. whether payments continue to the spousal beneficiary after the death of the annuitant.  The largest monthly benefit will always be the one that goes to $0 upon the death of the annuitant, leaving no residual benefit to a spousal beneficiary.  For a smaller benefit amount, the annuitant can elect for the benefit to continue in some percentage amount (usually 100%, 75%, or 50%) until the death of their spousal beneficiary (assuming it occurs subsequently to their own).  The smallest monthly benefit amount will be the one that offers the same monthly benefit amount (100% of the original) across both your and your spousal beneficiary’s lifetimes.

Personal and Spousal Longevity

Detail and assess your family history to understand your and your spouse’s longevity.

The question of how many years of life must be sustained will materially impact the output of a quantitative analysis.  This impact can be additionally enhanced by a significant age difference between the annuitant and his or her spouse.  A spousal beneficiary who is 20 years older than an annuitant would likely mitigate the appeal of any survivorship benefit.  Poor health and/or longevity expectations and a desire to leave money to heirs may shift favor significantly toward choosing the lump sum option.  An annuitant with both longevity and a significantly younger spouse may find the value of the lump sum alternative severely diminished once factoring in life-expectancy considerations.

Cash Flow and Liquidity Needs

Compile an estimate of your expected net cash flow over the first five years of retirement and include an itemization of any anticipated ordinary expenses.  Be sure to accurately account for taxes as part of your cash outflow. 

The amount of money you need to live may not entirely align with the structure of a fixed annuity. 

A large cash flow surplus is a good thing.  But it is also a reason why selecting an annuity option may not make sense.  Why be taxed on money you do not need to receive when that money could continue to grow tax-deferred?  Though you may live well within your means, anticipated and unanticipated expenses will occur.  Will your income and other assets be sufficient to meet any need that should arise?  Both options – the annuity and lump sum – provide access to liquidity, though only the lump sum allows you to access the totality of your benefit immediately.


Define your priorities


The ‘best’ decision as defined quantitatively is not always the decision that is most suitable for you. 

The same benefit inputs can generate different recommendations based on the totality of considerations.  Having a firm sense of what is more important and what is less important to you and the costs and benefits therein will enable you to make a decision in which you can have comfort and confidence.


Evaluate comprehensively


Understanding the full range of considerations and having the tools to quantitatively assess and compare empowers an informed decision.

As wealth advisors and financial planners, we understand the full range of considerations applicable to choosing a retirement benefit.  We test and confirm that our recommendations are supported by the quantitative data. 

Guaranteed inflation-adjusted income for a lifespan that will likely exceed 100 years? Why wouldn’t anyone take that? 

To appreciate the depth factors underpinning the decision, consider the example below of an unmarried annuitant with good longevity deciding between a CPI-adjusted single-life annuity benefit or a lump-sum.  Though a single point of consideration may favor one option over the other, the decision is fundamentally comprehensive and should be evaluated as such.

In this case, if the benefit is awarded at age 62 and the annuity is selected, the income is immediately taxed as ordinary income in the year received.  By contrast, if the lump sum is selected, that amount can be deposited into an individual retirement account (IRA) without any taxes due until the money is withdrawn.  In this case, withdrawal- i.e. taxation- could be deferred for an additional decade while the growth of that money compounds. 

Because this example pays a high tax rate on income and is running a cash flow surplus, even a low rate of return on a lump sum would stand a good chance of generating more wealth over a remaining lifetime due to the tax-deferred compounding growth in the initial decade following retirement.  Of course, reasoned assessment should always be confirmed with a rigorous data-driven analysis that incorporates multiple probability simulations.

Ultimately, though the numbers may drive the analytical process, it is the comprehensiveness of the analysis that benefits your confidence in the decision and your peace of mind.

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