Annuity vs. lump sum

The situation

As companies offer more defined contribution plans, employees are being increasingly called on to be more actively involved in the management of their retirement finances.

But even those employees who still have defined benefit plans may need to choose between a lifetime monthly annuity benefit and a one-time lump-sum payment (sometimes referred to as a "pension buyout").

The monthly-payment option

A defined benefit plan usually offers several monthly payment options, including the following (in descending order of payment amounts): 
  • Single life payment: Pays the highest monthly benefit, but terminates at death.
  • Single life with term certain: Promises a regular payment for a pre-set period; should an individual die before then, the beneficiary will continue to receive a benefit over the remaining period of time.
  • 50% joint and survivor: Ensures that a surviving spouse receives monthly payments for the rest of their life equal to one half of the original benefit.
  • 100% joint and survivor: Typically provides the lowest monthly benefit, but ensures lifetime payments to a spouse at the same amount.
The main advantage of this option? A regular, monthly stream of income. The main disadvantage? The plan's ability to meet its payment obligations. If a plan fails, the Pension Benefit Guaranty Corporation (PBGC), a federal agency, may make payments up to a legal limit. There are other potential drawbacks as well. For example, if someone retires before meeting a plan's normal retirement age threshold, the benefit will likely be frozen until the individual starts to receive it. In other words, the benefit stops growing when the recipient stops working for that company. Even after payments begin, they may not come with inflation protection, or cost-of-living adjustments (COLAs), resulting in a loss of buying power over time. Also, a retiree may face a large, unexpected expense, and a monthly benefit may fall short in meeting it.

The lump-sum option

The potential disadvantages of an annuity are exactly what can make a lump-sum payment appealing: a large cash payment now. The main benefit, though, is the flexibility to invest the lump-sum payment. Any money remaining at death goes to designated beneficiaries. However, this benefit comes with a substantial challenge: making that money last. Market fluctuation and periodic withdrawals to meet ongoing expenses could deplete this resource and put the recipient at financial risk. You may want to explore annuity products that offer principal protection and guaranteed income streams as an alternative.   There is also the matter of federal (and possibly state and local) income taxes. If an individual doesn't roll over the proceeds from the lump sum into an IRA or an employer-sponsored retirement plan, the distribution will be treated as ordinary taxable income. Depending on the size of the payment, it could push an individual into a higher marginal tax bracket. What’s more, a recipient under the age of 59½ could incur a 10% penalty for early withdrawal. Of course, individuals have the option to take all or a portion of the lump sum to purchase an immediate annuity. It can be difficult to duplicate an annuitized monthly benefit, though, because an individual usually lacks sufficient negotiating power.

Making the choice

In light of these facts, here are some key considerations to keep in mind when deciding between lump-sum and annuity payments with the help of a trusted tax, legal, and/or financial professional:

Life expectancy: Monthly benefit and lump-sum payments are products of actuarial calculations. However, the underlying assumptions in the calculations may not accurately account for an individual’s personal and family medical history. Someone expecting a longer-than-average life span would take comfort from the prospect of a monthly stream of income. Conversely, a shorter-than-average life expectancy might favor a lump-sum payment.

Projected annual income needs: Individuals who already have sufficient income sources—through Social Security, other pension benefits, or a large portfolio— might find an annuity less attractive than a lump sum.

Inflation: Unless the annuity payment contains a COLA provision, that monthly payment will eventually lose ground to inflation. A lump sum, by contrast, can be allocated across asset classes as a hedge against inflation, but this approach also entails investment risk.

Convenience: Managing a lump sum for retirement income requires active involvement in terms of planning, budgeting, and discipline. If an individual is uncomfortable with investing and planning or disinclined to take the time, then a regular, monthly payment may be desirable.

Gift and estate planning: While wealth transfer may not be an immediate concern, it may become important once living expenses are adequately covered. A pension plan doesn’t usually offer the ability to transfer benefits to children or grandchildren. However, a lump sum could provide heirs with additional resources.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Investing involves risk, including risk of loss.

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