Investing a Lump Sum vs. an Annuity
Does your employer offer a traditional defined-benefit pension plan that provides you a monthly payment for life when you retire? If so, congratulations—such plans are far less common today.
With a pension, you may face a challenging choice at—or in—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?
If you choose the annuity route, the decision can become more perplexing when payment options vary. Here are a few examples:
- Single life payment: This typically pays the highest monthly amount. When you die, there are no further payments to your beneficiaries.
- 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 the original annuity payments.
- 100% joint and survivor: You receive an even lower monthly payment, but in return, your surviving spouse gets 100% of the original annuity payments for his or her life.
Your decision can have major financial implications, so consult with a professional financial or retirement planner and chose carefully. Here are some important factors to consider.
Your 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 being 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 monthly payments, paid for life, more attractive than relying on their ability to extract income for the same uncertain time period from a portfolio, while those in poor health who don’t expect to live beyond the average may find more benefit from the lump-sum option.
Example: Imagine your company provides a pension, and offers you at age 65 a single life annuity of $1,470 per month ($17,640 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 $17,640 per year ($1,470 x 12 months) amounts to an annual payout of 5.9% on $300,000 ($17,640 ÷ $300,000 = 5.9%). You may conclude that 5.9% is hard to consistently get from investments without taking on significant risk.
In order to do a more 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 5.9% “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, at age 65, you assume a life expectancy of 18 more years, then the annuity’s internal rate of return—a measure similar to the anticipated investment return—is around 0.6%. In other words, if you withdrew $17,640 per year in both investment earnings and principal on your $300,000 lump sum, you’d need to earn an annual return of 0.6% on average through retirement to make it last for 18 years. In fact, the $300,000 would last a little over 17 years even with a 0% return ($300,000 ÷ $17,640= 17).
However, if you live longer than average, the internal rate of return on the annuity goes up. In this example, if the individual lived to age 90 (25 years) the rate of return needed from a portfolio would be 3.2%, and to age 95 (30 years) 4.1%. You may, or may not, be able to do better by investing.
The internal rate of return isn't a simple number to calculate, and it isn't reported by an annuity or pension provider. You'll need a computer or calculator—or to work with an advisor.
The questions to ask are: How concerned are you about managing investments and payments yourself? How long do you expect you or your spouse will live? Do you have other investments in combination with, and in addition to, a pension or annuity, for a balance of protections and growth potential?
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 generally becomes because of the guaranteed lifetime payment.
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.
Taking care of others
If you have a spouse who will need support after you pass, consider whether you have other investments that can support a comfortable retirement for him or her. Otherwise, one of the survivor benefit options listed above can help their (and your) security and peace of mind.
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 about 2.5% on average annually over the long term, based on Schwab’s current 10-year capital market expectations. Double that equity allocation to 40% with a 50% allocation to bonds and 10% to cash—a riskier hypothetical portfolio—and our 10-year estimate is about 3.5% per year1, less than the annuity’s rate of return in the 30-year example above.
If you invested a lump sum on your own, how confident are you that you'd beat the rate of return from the annuity if you live a long life in retirement? This is a critical issue when considering whether to take the monthly payment or the lump sum and invest.
Other factors: Income needs, 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 invest either your annuity payments or a lump sum for future use or include it in your gift and estate program.
- 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 guaranteed (for example, provided from Social Security, pension or other 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 certain pension participants in the private sector, 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 (subject to the financial strength and claims-paying ability of the insurance company) 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. Or couple a pension with a portfolio of investments to provide a combination of both. 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.
- Convenience: When your work paychecks stop, 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. 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. 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. This baseline may include a pension or annuity. Annuity guarantees are subject to the claims-paying ability of the issuing insurance company.
For many retirees, having a baseline of income in place can increase comfort and confidence and help in managing other investments more flexibly. Consider your situation and tolerance for 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) 2021 Model Portfolio Estimates. Forward estimates contain certain risks and uncertainties. There can be no guarantee of future performance.
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