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Lump Sum vs. Annuity

Does your employer offer a traditional defined-benefit pension plan that provides you a monthly pension payment for life when you retire? If so, congratulations—such plans are far less common today. Most employers have shifted toward 401(k)s, 403(b)s and other defined-contribution plans over the past few decades, meaning more and more workers must rely on their own savings and investments to supplement Social Security and other sources of retirement income.

However, with a pension—also typically known as defined-benefit plan—you may face a challenging choice at retirement: Should you take a one-time lump-sum payout or opt to receive a monthly annuity payment for the rest of your life and, in some cases, the life of your spouse or beneficiaries as well?

The decision can become more perplexing, if you choose the annuity route, when your annuity payout options vary, possibly including:

  • Single life payment: This typically pays the highest monthly amount.
  • Single life with term certain: You receive a little less each month, but if you die before the specified term is over, payments continue to your beneficiaries for a preset number of years.
  • 50% joint and survivor: You receive a lower monthly payment to make sure your surviving spouse gets monthly payments for his or her life that are equal to 50% of your original annuity.
  • 100% joint and survivor: You receive an even lower monthly payment, but in return, your surviving spouse gets 100% of your annuity in monthly payments for his or her life.

Your choice can have major financial implications, so make a careful decision, in consultation with a professional financial or retirement planner. Here are some important factors to consider as you work your way toward a decision.

Life expectancy

The simplest analysis compares the monthly annuity payment offered with what you believe you could generate yourself by investing the lump sum at a similar level of risk. There are three critical assumptions in this analysis: an assumption about your life expectancy, the return on your investments, and the risk—or certainty—of the return on those investments. Life expectancy is the most important.

As a general rule, people in good health or with good reason to believe they, or their spouse, will live beyond the average life expectancy may find the lifetime payment (i.e., annuity) more attractive, while those in poor health who don’t expect to live beyond the average may find more benefit from the lump-sum option. There are other factors to consider, to be covered below. For now, let’s focus on life expectancy.

Example: Imagine your company provides a pension, and offers you at age 65 a single life annuity of $2,000 per month ($24,000 per year) for life or a lump-sum payment of $300,000. At first glance the annuity may appear to be the clear winner, as $24,000 per year ($2,000 x 12 months) amounts to an annual payout of 8% on $300,000 ($24,000 ÷ $300,000 = 8%). You may conclude that 8% is hard to get from investments, consistently through retirement, without taking on significant risk.

In order to do an apples-to-apples comparison, however, you need to keep in mind that the annuity takes a total-return approach (meaning that it assumes you will use both principal and investment returns during retirement, leaving a zero balance) with built-in assumptions about how long you will live. The 8% “return” is a rate of payout from the $300,000, including a gradual payout of your $300,000 principal. It isn’t a rate of return.

If you assume a life expectancy of 18 more years at age 65, then the annuity’s internal rate of return—a measure similar to the anticipated investment return—is around 4.2%. In other words, if you drew down $24,000 per year in both investment earnings and principal on your $300,000 lump sum, you’d only need to earn an annual return of 4.2% on average through retirement to make it last for 18 years. In fact, the $300,000 would last 12½ years even with a 0% return ($300,000 ÷ $24,000 = 12.5).

Remember, though, that how long you actually live is one of the more significant risks faced by retirees.The longer you live beyond your actuarial life expectancy, the better the annuity option becomes, generally, because of the guaranteed lifetime payment. However, if you are in poor health, you may find the lump sum more attractive. You might also view a pension with the annuity option as a form of insurance, to help manage the risk of outliving the lump sum, as well as the uncertainty of market returns.

For example, assuming you receive a check for $2,000 at the beginning of each month and live 25 years to age 90, your annual compounded rate of return would be roughly 6.6%. And if you live 30 years, to age 95, the annuity’s yield to maturity jumps to approximately 7.3%—not a bad rate when compared to current high-quality bond yields of similar maturity.

If you chose a payout based on your own life expectancy with no survivor benefits and you died after the first year, the insurance company would benefit. But consider other assets you may have, such as other retirement savings, if you want to leave money behind.

TIP: Be sure to use a reasonable estimate of what your lump-sum investment might earn. Today, we think a hypothetical conservative portfolio of 20% equities, 50% bonds and 30% cash could grow 3.5% on average annually over the long term, based Schwab’s current 10-year capital market expectations. Double that equity allocation to 40%—a riskier hypothetical portfolio—and our 10-year estimate is 4.5% per year1, less than the annuity’s rate of return in the 30-year example above.

Other factors: Income needs, health, taxes and more

Here are some additional factors to consider.

  • Current income needs: If you already have sufficient sources of retirement income (a large portfolio, Social Security, other forms of lifetime income including existing annuities, etc.), you could either invest annuity payments or take a lump sum and invest it to potentially grow for future use or include it in your gift and estate program.
  • Health: If you outlive the life expectancy for the average male or female American your age, you may end up receiving higher lifetime income with the annuity. If you end up living fewer years than the average for individuals your age, a lump sum may be more attractive. (If you’re married, you’ll want to take your spouse’s potential longevity into account as well.) Remember, if you choose an annuity, you’re choosing a lifetime cash flow. If you choose a lump sum, you generally will have more control over the asset, but not the promise of a lifetime cash flow. Balance annuity payments with other savings and resources, though. If you have a single, large expense, like a health-care event, you may need money to pay for large expenses or bills in excess of Social Security and annuity payments.
  • Risk: In retirement, reliability of cash flows can be important for many retirees. A steady monthly check regardless of what’s happening in the markets can be helpful. First, ask yourself, how much of your retirement income will depend on markets, and how much is insured (e.g. provided from Social Security, pension or annuity)? Do you feel comfortable with this balance? If not, consider the annuity. If so, consider the lump sum.
  • Credit quality: If choosing an annuity payout, check the credit rating of the annuity provider or pension fund. (The Pension Benefit Guaranty Corporation, or PBGC, is a federal government agency that provides protection for pension participants, but the protection is not unlimited.) Then consider the advantage of turning over the risk of investment performance for a portion of your retirement cash flow to others, rather than taking on all of that risk yourself.
  • Inflation: Unless the annuity payment carries a cost-of-living adjustment, you’ll lose purchasing power over time. A lump sum could be invested to include a prudent allocation of equities and TIPS (Treasury Inflation-Protected Securities) to help assets have a better chance of keeping up with inflation. Of course, doing so would involve taking on some market risk and doesn’t ensure that income will last for the life of the annuitant, subject to the financial strength and claims-paying ability of the insurance company.
  • Convenience: When your paycheck from work stops, there’s something to be said for a monthly check that automatically arrives in your bank account—especially if you plan on doing things besides managing your portfolio during your retirement. You could work with a financial advisor to implement a total-return strategy that generates income from your portfolio if you don’t want to do it yourself.
  • Cost comparison: Managing a lump sum yourself likely involves some investment costs (management fees, transaction fees, etc.). Such costs are already factored into the annuity choice. You may want to do some comparison shopping for the income paid from several high-quality, low-cost providers for an equivalent lump sum, and compare it to the annuity payment offered by your pension plan.
  • Taxes: If you opt for a lump-sum payout, one option could be to roll it over to a traditional IRA and continue to defer taxes. If you take a lump sum and don’t roll it over, you’ll pay a large, single tax bill. Check to be sure a rollover is permitted, whether you could roll over the lump-sum into your employer’s retirement plan, and talk with a financial advisor and tax professional about the advantages and disadvantages of rollovers to an IRA.
  • Gift and estate planning: Unless you choose a term certain or survivor benefit option, your annuity ceases when you die. A lump sum could be passed on to heirs, if a balance remains. Be sure to factor your gift and estate planning goals into any lump sum versus annuity decision, along with the additional factors above.

What about both?

You might choose to take a lump sum and then choose to use a portion of it to purchase a high-quality, immediate fixed annuity. One approach may be to aim to cover as much of your essential, fixed expenses as possible from Social Security or other forms of predictable and, if possible, guaranteed income sources, subject to the claims-paying ability of the issuing insurance company. For many retirees, this can increase comfort and confidence and help in managing other investments more flexibly, with a baseline of income in place. Consider your situation, however, and tolerance for managing market, longevity and other retirement risks.

For additional guidance, and a plan for your retirement, consider all of your assets and potential income sources, including a pension, and how they’ll work together to support your retirement.

¹ Source: Charles Schwab Investment Advisory (CSIA) 2017 Model Portfolio Estimates. Forward estimates contain certain risks and uncertainties. There can be no guarantee of future performance.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and are not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Investing involves risk including loss of principal.

Treasury Inflation Protected Securities (TIPS) are inflationlinked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options, which may include but are not limited to, keeping your assets in your former employer’s plan, rolling over assets to a new employer’s plan or taking a cash distribution (taxes and withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment‐related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

Annuity guarantees are subject to the financial strength and claims‐paying ability of the issuing insurance company.

Please note that annuity withdrawals are taxed as current income, not capital gains. This may or may not be beneficial, depending on your tax bracket. Please consult a tax or accounting professional.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (Member SIPC).


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