Should You Take Your Pension As Lump Sum Or Annuity?

Summary/TL;DR

When choosing between a lump sum or a lifetime annuity, the most important number to take into consideration is the internal rate of return (IRR). Pensions with a relatively high IRR favor the annuity option, and pensions with a relatively low IRR favor the lump sum. In addition, the lump sum option often has considerable advantages over the annuity that should be considered as well. These include the flexibility to make Roth conversions of the lump sum at low tax rates throughout retirement, the ability to take higher distributions from your lump sum over time to account for inflation, and protection of your heirs from a premature death.

Introduction

If you’ve worked at a company that offers a pension, then you’ve likely faced the relatively daunting decision of choosing how to claim your pension – as a lump sum, taken all at once and rolled over into a Traditional IRA, or as a lifetime annuity. This massive decision can have a dramatic impact on the success of your retirement and is not one that should be made lightly.

In this post, I aim to provide insight into how I think through this decision for my clients to guide them to a recommendation. And while this is certainly a problem in which everyone’s individual circumstances will dictate the overall solution, there is one metric that can almost always serve as a good starting point for analysis.

The Internal Rate of Return

By far the most important number in this analysis is what’s known as the internal rate of return (IRR) of your pension. The IRR will give you the rate of return that an alternative investment (like stocks and bonds) would have to “beat” to make it worth giving up the pension for its lump sum payout. For example, if you determine that the IRR of your pension is 4% but believe that you can reasonably earn 6% in the stock market, then you should take the lump sum and invest in the stock market.

To compute the IRR of your pension, you need to know three things:

1. The amount of time you will be receiving your pension, which would be your life expectancy minus your age when your pension begins.

2. The amount your pension will pay you monthly.

3. The amount you can take as a lump sum.

For example, let’s say I’m 60 years old and have the option to take either a $5,500/mo pension for the rest of my life, or take a lump sum of $1,100,000. If I live until I’m 80, then the IRR of my pension is only 1.9%, and if I live until I’m 90, then the IRR of my pension is 4.4%. In both cases, I’ll likely be better off taking the lump sum.

The visual below can help conceptualize this. In this example, I’ve retired 30 years ago today and invested my $1,100,000 lump sum into a 70% stock, 30% bond portfolio. Every month, I withdraw $5,500 to replace what I would have drawn from my pension if I had taken it as an annuity.

Because the return in my portfolio was higher than the IRR of my pension taken as an annuity, I still had money left over at the end of the period. In this case, since the return was far higher than the IRR of my pension, I had a large amount left over.

While the IRR is an important starting point for making this decision, there are also other, non-quantitative, considerations that should be kept in mind.

Additional Considerations

Tax Diversification and Flexibility

Of course, the tax ramifications of taking your pension as a lump sum or annuity can differ drastically.  What the lump sum option lacks in security, it makes up for in flexibility. When you receive your pension as an annuity, it will always be taxed as ordinary income, greatly limiting your ability to control your taxable income in retirement. And if tax rates rise at any point during your retirement, there’s nothing you can do to keep your pension from being taxed at higher rates.

If you take the lump sum, however, you can roll it over into a Traditional IRA and convert it to Roth throughout your retirement, affording you great amounts of flexibility. Depending on your other income sources, your age when you retire, and your income needs in retirement, this could be an exceptionally valuable tool to have at your disposal. If, for example, you go into retirement already tax diversified, you can convert large amounts of your lump sum to Roth at very low tax rates and never pay taxes on it again.

Inflation

In a similar fashion to the above, many pensions are inflexible in their ability to adjust to inflation over time, which is a significant weakness. Assuming you have a pension that pays $5,500/mo, consider the following: after 30 years of inflation averaging 3%, that pension will only go as far as $2,205 today.

If you exercise the lump sum option, however, your performance in the stock market should outpace inflation by leaps and bounds over a 30-year period, even if you retired at the onset of a downturn. Continuing the example above, suppose I retired when I was 60 and exercised the lump sum option of $1,100,000. This time, however, choose to adjust my $5,500/mo distributions for inflation.

While this dramatically reduced my ending portfolio value at the end of the 30-year period, I still made out exceptionally well! Now, at 90 years old, I’m taking $11,667/mo from my portfolio and still have over $1.6M to pass on to my heirs or assist in funding long term care expenses. Had I taken my pension as an annuity, I would still only be receiving $5,500/mo and would have $0 in my portfolio.

Inheritance

The final advantage that a lump sum pension has over the annuity is that it guarantees that someone gets a benefit, which is especially important in the case of a premature death. Imagine if you and your spouse passed together in a tragic accident only 5 years after retiring. Resuming our example above, you would have only received $330,000 in income from your pension, but you’re your heirs would receive nothing! Taking your pension as a lump sum protects your heirs from this unfortunate circumstance.

Conclusion

While this post has covered some of the most important considerations in this massive decision, it has still only scratched the surface. You should always consult a competent and knowledgeable professional before you make your decision, especially if your pension is a sizeable one that has accumulated over decades of working for the same company. Making the “wrong” decision here can easily amount to a million-dollar mistake, which is not likely something that your retirement plan can afford to endure.