Think Twice when Choosing a Lump-Sum or an Annuity

Even though it looks like a lot of money, taking a lump-sum payout from a pension plan may not be the best choice for a worker making retirement decisions.

Traditional private pension plans provide workers with lifetime monthly payments, known as annuities, but some plans also provide workers with the option of receiving their pensions as lump-sum distributions. While lump-sum distributions are dispersed as a one-time payment, annuities pay benefits over a period of time, such as the worker’s lifetime, or the lives of both the worker and his or her spouse.

One big advantage of annuities is that workers (and their surviving spouses, depending on the type of annuity selected) will never outlive their money - the monthly payments are guaranteed for life. By taking lump-sum distributions, workers become responsible for investing the money and making sure it can last as long as they need it.

There are also other factors to consider when deciding to take an annuity. For example, a disadvantage of many annuities is that they are not adjusted to reflect increases in the cost of living.

Another potential disadvantage with annuities is that larger benefits are only guaranteed up to the maximum amount allowed by the Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures private pension obligations. If a retiree's monthly annuity payment is larger than the PBGC's monthly maximum guarantee and their financially-distressed former employer terminates the pension plan without enough assets to pay all the promised benefits, the most the retiree can receive is the maximum amount guaranteed by the PBGC.

Before deciding to take a lump-sum distribution workers should know the exact amount of their benefit. For example, the Pension Protection Act of 2006 changed the interest rate pension plans use to determine the amount of lump-sum distributions. This can result in workers receiving smaller lump sums than they would have received with the previous interest rate.

Another factor to consider before taking a lump-sum payout is that some pension plans offer subsidized retirement benefits, such as unreduced early retirement pensions. Workers should know that plans are not required to factor the value of the subsidized retirement benefit into the lump sum. This could cut the value of the expected benefit by more than half. Plans are required by law to inform workers about the relative value of a subsidized benefit compared with the lump-sum payout.

There are many factors to keep in mind when preparing for retirement and everyone's situation is different. We encourage workers to think carefully about the consequences if given the opportunity to choose whether to take a pension as a lump-sum distribution or an annuity.