Pension Payouts: Lump Sum vs. Annuity

October 16, 2023 Rob Williams
Should you take a lump-sum pension payout or a monthly income stream for life? How to decide.

If you have a traditional defined-benefit pension plan, at some point you'll have to decide how to receive that money: Do you want a one-time lump-sum payout, or a lifelong series of monthly annuity payments?

Cash in hand can feel good, and you can potentially generate extra returns by investing your lump sum—assuming you can manage the risk. Annuity payments, on the other hand, are guaranteed for life, assuming the provider remains solvent. They can even be extended to the life of a spouse (in fact, annuities can provide a lot of different options, as we'll see below). You will have to give up some flexibility in exchange.

You might start with an emotional preference for one or the other, but be sure to compare them, preferably with help from a financial professional, before making any decisions. Here are some thoughts on how to do that.

Your life expectancy

At the most basic level, the choice comes down to what you think might be a better deal. To determine this, you'll need to make some assumptions about what kind of returns you can hope to generate from your investments in exchange for assuming a given amount of risk.

Most importantly, you'll need to put a timeframe on your calculations. After all, it's hard to put a value on "lifetime" payments without estimating how long you might live. Similarly, you can't be confident a lump sum might last your whole retirement if you don't have a reasonable expectation of how long that might be.

Putting some numbers and assumptions behind these ideas helps.

Example

At age 65, you can choose between 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 better, as $17,640 per year is equivalent to that $300,000 consistently generating an annual return of 5.9% ($17,640 ÷ $300,000 = 5.9%). You may conclude that that would be tough to do on your own without taking on significant risk.

However, this wouldn't be an apples-to-apples comparison. Why? Because it doesn't include any of the $300,000 of principal. While it would be great to support yourself entirely with the income from your investments and never have to touch any of your principal, it's tough to do so consistently without significant wealth. (Constructing an income stream that is part principal, part investment return is called a total return approach.)

In any case, an annuity payment isn't a simple "return" on your $300,000 either. Rather, annuity payments are a combination of principal and investment returns and are designed to draw down to zero over your expected lifespan, as calculated by the insurer. That's not to say you'll be cut off once you hit your life expectancy, as we'll see below, but that's how insurers make calculations.

So, if at age 65 you assume a life expectancy of 18 more years, then $17,640 of annual annuity payments amount to payments of $317,520. That's equivalent to an annual return of just 0.6% on the $300,000 lump sum. In fact, even if you made a 0% return on a $300,000 lump sum, it would still last a little over 17 years if you withdrew $17,640 a year ($300,000 ÷ $17,640 = 17). In this case, the lump sum looks pretty good.

But what if you live longer than average? Then the annuity payments start to look better, as the return from your portfolio would have to be higher to be equivalent. For example, if you lived to age 90 (a 25-year retirement) you would need 3.2% annual returns from your portfolio to match the annuity. If you lived to age 95 (a 30-year retirement), you would need 4.1% returns.

At age 65, you can choose between 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 better, as $17,640 per year is equivalent to that $300,000 consistently generating an annual return of 5.9% ($17,640 ÷ $300,000 = 5.9%). You may conclude that that would be tough to do on your own without taking on significant risk.

However, this wouldn't be an apples-to-apples comparison. Why? Because it doesn't include any of the $300,000 of principal. While it would be great to support yourself entirely with the income from your investments and never have to touch any of your principal, it's tough to do so consistently without significant wealth. (Constructing an income stream that is part principal, part investment return is called a total return approach.)

In any case, an annuity payment isn't a simple "return" on your $300,000 either. Rather, annuity payments are a combination of principal and investment returns and are designed to draw down to zero over your expected lifespan, as calculated by the insurer. That's not to say you'll be cut off once you hit your life expectancy, as we'll see below, but that's how insurers make calculations.

So, if at age 65 you assume a life expectancy of 18 more years, then $17,640 of annual annuity payments amount to payments of $317,520. That's equivalent to an annual return of just 0.6% on the $300,000 lump sum. In fact, even if you made a 0% return on a $300,000 lump sum, it would still last a little over 17 years if you withdrew $17,640 a year ($300,000 ÷ $17,640 = 17). In this case, the lump sum looks pretty good.

But what if you live longer than average? Then the annuity payments start to look better, as the return from your portfolio would have to be higher to be equivalent. For example, if you lived to age 90 (a 25-year retirement) you would need 3.2% annual returns from your portfolio to match the annuity. If you lived to age 95 (a 30-year retirement), you would need 4.1% returns.

and investment returns and are designed to draw down to zero over your expected lifespan, as calculated by the insurer. That's not to say you'll be cut off once you hit your life expectancy, as we'll see below, but that's how insurers make calculations.

So, if at age 65 you assume a life expectancy of 18 more years, then $17,640 of annual annuity payments amount to payments of $317,520. That's equivalent to an annual return of just 0.6% on the $300,000 lump sum. In fact, even if you made a 0% return on a $300,000 lump sum, it would still last a little over 17 years if you withdrew $17,640 a year ($300,000 ÷ $17,640 = 17). In this case, the lump sum looks pretty good.

But what if you live longer than average? Then the annuity payments start to look better, as the return from your portfolio would have to be higher to be equivalent. For example, if you lived to age 90 (a 25-year retirement) you would need 3.2% annual returns from your portfolio to match the annuity. If you lived to age 95 (a 30-year retirement), you would need 4.1% returns.

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At age 65, you can choose between 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 better, as $17,640 per year is equivalent to that $300,000 consistently generating an annual return of 5.9% ($17,640 ÷ $300,000 = 5.9%). You may conclude that that would be tough to do on your own without taking on significant risk.

However, this wouldn't be an apples-to-apples comparison. Why? Because it doesn't include any of the $300,000 of principal. While it would be great to support yourself entirely with the income from your investments and never have to touch any of your principal, it's tough to do so consistently without significant wealth. (Constructing an income stream that is part principal, part investment return is called a total return approach.)

In any case, an annuity payment isn't a simple "return" on your $300,000 either. Rather, annuity payments are a combination of principal and investment returns and are designed to draw down to zero over your expected lifespan, as calculated by the insurer. That's not to say you'll be cut off once you hit your life expectancy, as we'll see below, but that's how insurers make calculations.

So, if at age 65 you assume a life expectancy of 18 more years, then $17,640 of annual annuity payments amount to payments of $317,520. That's equivalent to an annual return of just 0.6% on the $300,000 lump sum. In fact, even if you made a 0% return on a $300,000 lump sum, it would still last a little over 17 years if you withdrew $17,640 a year ($300,000 ÷ $17,640 = 17). In this case, the lump sum looks pretty good.

But what if you live longer than average? Then the annuity payments start to look better, as the return from your portfolio would have to be higher to be equivalent. For example, if you lived to age 90 (a 25-year retirement) you would need 3.2% annual returns from your portfolio to match the annuity. If you lived to age 95 (a 30-year retirement), you would need 4.1% returns.

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At age 65, you can choose between 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 better, as $17,640 per year is equivalent to that $300,000 consistently generating an annual return of 5.9% ($17,640 ÷ $300,000 = 5.9%). You may conclude that that would be tough to do on your own without taking on significant risk.

However, this wouldn't be an apples-to-apples comparison. Why? Because it doesn't include any of the $300,000 of principal. While it would be great to support yourself entirely with the income from your investments and never have to touch any of your principal, it's tough to do so consistently without significant wealth. (Constructing an income stream that is part principal, part investment return is called a total return approach.)

In any case, an annuity payment isn't a simple "return" on your $300,000 either. Rather, annuity payments are a combination of principal and investment returns and are designed to draw down to zero over your expected lifespan, as calculated by the insurer. That's not to say you'll be cut off once you hit your life expectancy, as we'll see below, but that's how insurers make calculations.

So, if at age 65 you assume a life expectancy of 18 more years, then $17,640 of annual annuity payments amount to payments of $317,520. That's equivalent to an annual return of just 0.6% on the $300,000 lump sum. In fact, even if you made a 0% return on a $300,000 lump sum, it would still last a little over 17 years if you withdrew $17,640 a year ($300,000 ÷ $17,640 = 17). In this case, the lump sum looks pretty good.

But what if you live longer than average? Then the annuity payments start to look better, as the return from your portfolio would have to be higher to be equivalent. For example, if you lived to age 90 (a 25-year retirement) you would need 3.2% annual returns from your portfolio to match the annuity. If you lived to age 95 (a 30-year retirement), you would need 4.1% returns.

How long you actually live is one of the more significant risks retirees face. The longer you live beyond your actuarial life expectancy, the better the annuity option generally becomes because of the guaranteed lifetime payment.

If you're in good health and value the protection and income you'll receive if you live longer than average, the annuity option may look more attractive. In this case, it's helpful to think of the value of the payments as a form of insurance to manage longevity, rather than as a simple payout or investment.

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.

Your family

What if you have a spouse who will need support after you pass? With a lump sum, you'll want to be confident that your investments can deliver the expected returns for as long as required—and see how that compares with the annuity payments. If you need help making reasonable assumptions, you can use our long-term capital market expectations.  

With annuities, you have more options. Here are some common ones:

  • 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.

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, maybe an existing annuity, etc.), then you could take either the annuity payments or a lump sum and simply invest them for future use. You could also include it in your gift and estate program.
  • Risk: For retirees, it can be nice to have a steady income that is insulated from the markets. So, ask yourself, how much of your retirement income will depend on markets, and how much is guaranteed (say, 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 agency that provides protection for certain pension participants in the private sector, but the protection is not unlimited.) Then decide whether you want to depend on them for a portion of your cashflow, or if you'd be better off going it alone.
  • 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 other than managing your portfolio during your retirement. That's a point in favor of annuities. You can also do it with a lump sum, though. 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, such as management fees or transaction fees. Annuities also come with costs and fees, which can include premiums and commissions. You may want to do some comparison shopping among low-cost providers to see how their payments stack up against 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, and 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.

What about both?

If you like features of both, you can choose both. For example, you could use a portion of a lump sum payment to buy an immediate fixed annuity and aim to cover as much of your fixed expenses as possible (with help from Social Security).

Either way, having a baseline of reliable income in place can make retirement more comfortable and allow you to be more flexible in managing the rest of your savings.

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. 

Asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and bond investments, when sold, may be worth more or less than original cost. Fixed income securities are subject to various other risks, including changes in interest rates and credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Treasury Inflation Protected Securities (TIPS) are inflation‐linked 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.

Please consider surrender charges that may apply upon terminating an annuity contract.

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

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

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