Lump Sum vs Annuity: Which Pension Option Is Better?

[alexabreana]

I am 2 years away from retirement, I work for the City of San Diego, I have worked for the City for 28 years,  My pension offers a 2% yearly Cola, My monthly pension is going to be $4K monthly for life, ($4k after tax) I am thinking of rolling the lump sum into a traditional IRA with Vanguard maybe VOO, not sure at this moment.  I am not sure if its best to take them lump sum or monthly payment for life, your advice is greatly appreciated.

Alexa

[GilesMM]

It depends on the amount of the lump sum.  If it is $1,000,000 you can invest that in a treasury note and get a 4.6% return over 30 years or $46,000/yr.  Risk free.  Best part - at the end of 30 year, you get your million dollars back!

[Ron Scott]

The answer is mostly about you.

The best candidates for annuities:
1. Expect to live a long life
2. Have a reasonable fear that their portfolio might not last a lifetime
3. REALLY NEED to live up to or above their means to have a good life in retirement
4. Don’t care about leaving an inheritance or actually prefer to die with $0 left

If you’re borderline, a better than average annuity might tip the balance. You can compare yours against others and a resource like mmediateannuities.com may help.

If you’re pretty sure you’re going to live below your means in retirement and like the idea of leaving money to loved ones, walk on annuities.

[Catbert]

Ron had really good points.  I'll also point out that as you get older your cognitive ability will likely decline.  How quickly and how soon varies tremendously by individual.  DH and I are in our 70s.  I'm still in charge of our investments but am definitely not as sharp as I was when I was 50.  DH is in the early stage of Alzheimer's so it's a good thing he's not in charge of our finances.

Once you've made a decision to get an annuity there are no ongoing decisions to be made.   

[Sandi_k]

Also worth noting that your COLA'd pension will move with inflation; I've heard that there are no inflation-indexed annuities these days.

One way to do a back-of-the-envelope calculation:

- Look at the lump sum.
- Look at the gross payment per month, and multiply by 12 (for the annual amount).
- Multiply the pension's annual amount x 25.

If the pension's 25 year total is higher than the lump sum, take the pension.

Another way:

- Get the figure for the lump sum.
- Go to https://qualifiedannuity.com and see what your lump sum can buy, and what the monthly amount would be. Remember it's not inflation-adjusted. But if it's in the ballpark of the pension payment, then take the pension (given the COLA). If the SPIA payment is much larger than the pension payment, take the lump sum and buy a SPIA.

There are lots of articles about "Is a SPIA right for you?" I would say NO if you have legacy plans for the kids; in that instance, the lump sum would be preferable as a rollover option, as you can then (presumably) control the asset for your heirs.

[Sandi_k]

Ron had really good points.  I'll also point out that as you get older your cognitive ability will likely decline.  How quickly and how soon varies tremendously by individual.  DH and I are in our 70s.  I'm still in charge of our investments but am definitely not as sharp as I was when I was 50.  DH is in the early stage of Alzheimer's so it's a good thing he's not in charge of our finances.

Once you've made a decision to get an annuity there are no ongoing decisions to be made.

But the pension payout as a monthly amount also means that there are no ongoing decisions to be made....

[elaine amj]

My take was that monthly payments are the safe, no-risk portion of the portfolio. And then the rest of investments can be in all stocks or whatever. But then I was looking at only small pension numbers in relation to a much larger investment portfolio.

COLA is a nice hedge against the future.

I’d suggesting considering worst case in both scenarios and decide on the risk you are willing to take on.


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[Catbert]

Ron had really good points.  I'll also point out that as you get older your cognitive ability will likely decline.  How quickly and how soon varies tremendously by individual.  DH and I are in our 70s.  I'm still in charge of our investments but am definitely not as sharp as I was when I was 50.  DH is in the early stage of Alzheimer's so it's a good thing he's not in charge of our finances.

Once you've made a decision to get an annuity there are no ongoing decisions to be made.

But the pension payout as a monthly amount also means that there are no ongoing decisions to be made....

Sandi - I was using "annuity" as interchangeable with "pension" so we're in agreement.

[Sandi_k]

Ron had really good points.  I'll also point out that as you get older your cognitive ability will likely decline.  How quickly and how soon varies tremendously by individual.  DH and I are in our 70s.  I'm still in charge of our investments but am definitely not as sharp as I was when I was 50.  DH is in the early stage of Alzheimer's so it's a good thing he's not in charge of our finances.

Once you've made a decision to get an annuity there are no ongoing decisions to be made.

But the pension payout as a monthly amount also means that there are no ongoing decisions to be made....

Sandi - I was using "annuity" as interchangeable with "pension" so we're in agreement.

Fair - but I wanted to make the distinction crystal clear for the OP, as buying a non-indexed annuity is NOT the same as a pension payout with a COLA.

[TimCFJ40]

Generally, the payout is based on something around a 6% return providing your monthly payout. 

If you're disciplined, invest the lump sum, and withdraw less than 4% when you retire you're better off taking the lump sum.  Plus when you die, any remainder goes to your heirs, charity, or wherever you like, versus the coffers of the pension. 

Even if you expect to beat the actuarial tables for age, if you invest wisely and can stick to the 4% withdrawal rule you'll die with more than today's principle in the account.  Don't think that if you live long and take the pension until you're 100 that you beat the system, you just missed out on even more years of gains you could have had if you took the lump sum 40 years ago.

The only case where I wouldn't advise the lump sum is if you have a spending problem, and need to protect your money from yourself, or if you REALLY need or want the security of the defined benefit  and have other non pension assets as well. 

[Sandi_k]

Don't think that if you live long and take the pension until you're 100 that you beat the system, you just missed out on even more years of gains you could have had if you took the lump sum 40 years ago.
 

This is not true for my pension. The monthly COLA'd income will be equivalent to $4m with a 4% SWR ($160k). The lump sum is under $2m. And I also lose medical coverage in retirement if I take the lump sum.

[Chris Pascale]

The annuity can be a nice complement to a very long life.

My grandmother is approaching 100, and still receiving her and my grandfather's pensions (grandpa opted for the lower payment so that it would outlive him).

[TimCFJ40]

Don't think that if you live long and take the pension until you're 100 that you beat the system, you just missed out on even more years of gains you could have had if you took the lump sum 40 years ago.
 

This is not true for my pension. The monthly COLA'd income will be equivalent to $4m with a 4% SWR ($160k). The lump sum is under $2m. And I also lose medical coverage in retirement if I take the lump sum.

Sandi, I assume you are accounting for market growth of the lump sum after you would have taken it?  Does the $160k payment start today, and is the $2m payment the payment if you cashed in today?  If so, then yes in your case, a $2m current value lump sum is worth less than $160k per year starting today and you should keep with the annuity scenario. 

 Medical care is a separate issue and is a nice benefit to go along with the pension annuity option in your case. 

[GilesMM]

An advantage of the annuity payments is that they can be less susceptible to loss from liability judgments than an invested lump sum.

[reeshau]

I'm sure OP is aware of this, but a quick Google in San Diego's pension brings up some past shenanigans and present concerns.  City pensions can go bust; it happened to Detroit.

The most old-school thing about pensions is leaving your financial future in someone else's hands.  Technically, all fund and stock investing is doing that, too--but this is another layer.

[Sandi_k]

Don't think that if you live long and take the pension until you're 100 that you beat the system, you just missed out on even more years of gains you could have had if you took the lump sum 40 years ago.
 

This is not true for my pension. The monthly COLA'd income will be equivalent to $4m with a 4% SWR ($160k). The lump sum is under $2m. And I also lose medical coverage in retirement if I take the lump sum.

Sandi, I assume you are accounting for market growth of the lump sum after you would have taken it?  Does the $160k payment start today, and is the $2m payment the payment if you cashed in today?  If so, then yes in your case, a $2m current value lump sum is worth less than $160k per year starting today and you should keep with the annuity scenario. 

 Medical care is a separate issue and is a nice benefit to go along with the pension annuity option in your case.

Agreed. Which is why blanket statements that an annuity is worse than a lump sum is not one that should be taken at face value. It can be complicated by things such as other benefits (health care), the solidity of the funding agency, COLAs, and life expectancy.

I encourage the OP to think of all these dimensions, and to ask questions.

In terms of exploring financial solidity, Boston College has a great tool that assesses pension funding. Their Public Plans Data website has:

plan-level data for 229 state and local pension plans;
over 100 variables; and
annual data since 2001.

https://crr.bc.edu/project-page/public-plans-database/

[dcheesi]

What are people's thoughts for when one spouse has a pension, and the other has a 401k? Normally I'm Team Lump-Sum, but it occurs to me that taking the pension as an "annuity" in this case might provide a hedge against unforeseen loss of capital in the lump-sum accounts¹?

¹Not just poor money management, but also paranoid-but-possible things like legal liability (nod to @GilesMM ), or your account getting hacked, or cleaned out by an unscrupulous advisor, etc.?

[reeshau]

You can think of an annuity (including a pension) as a fixed-income portion of your portfolio; essentially, the same bucket as bonds.  Whatever your appreciation of or need for them vs. a stock portfolio is probably similar to other safe (i.e. less volatile, historically) investments.  While annuities may seem even more stable than bonds, particularly given the interest rate environment of the last 2 years, much of that is simply because annuities aren't publicly traded after issuance.  But someone who bought an annuity 5 years ago is locked in a situation the reverse of a 30-year mortgage holder: being paid at a low expected rate of return, with no way to change it.  Pensions somewhat smooth this out because the payout promise is based on income, but the attainment still considers a very conservative assumption of appreciation of underlying assets.  If you are a confident investor in the stock market, you can probably beat it, because you don't have to provide guarantees to anyone else.

For modeling purposes, some people see a pension as a direct reduction of a retirement income goal for savings.  This might be even more effective for a pension with COLA.  Another way to approach it is to approximate the equivalent market value by getting a quote from an annuity provider for an annuity paying out similar to the pension.  This would effectively be the value of your fixed income investment.  Either way, having that security would allow you to be more aggressive with your investments, so you can weight the stock portion of your 401k with the whole portfolio in mind.

[Ron Scott]

What are people's thoughts for when one spouse has a pension, and the other has a 401k? Normally I'm Team Lump-Sum, but it occurs to me that taking the pension as an "annuity" in this case might provide a hedge against unforeseen loss of capital in the lump-sum accounts?

When you say “pension” I believe you mean the option to annuitize the cash balance benefit in a defined benefit plan?

FWIW, calling this an “option” is a campy sales strategy since the beneficiary can buy an annuity from any insurer, not just the plan administrator and not just for the total balance LOL.

In any event YES, an annuity can be a good hedge against funds you manage yourself as an investor to support retirement, given the right circumstances, and if you choose to annuitize part or all of that cash balance DEFINITELY shop around with other insurers for the best plan. I will bet you a dollar the plan administrator’s option is not the most competitive.