Your pension: Lump sum or lifetime payments?

  @Money November 21, 2012: 6:56 AM ET
NEW YORK (Money Magazine)

I've been offered a choice between taking a lump sum payment from my defined-benefit pension plan from a previous employer or taking an annuity and leaving the plan. The lump sum is $200,000. Should I take the lump and roll it into an IRA or go with the annuity? -- Steve P., Petersburg, W.Va.

Most traditional corporate pension plans only allow you to take your benefits as an annuity, or a series of monthly payments for the rest of your life (or long as your spouse is alive). But more companies, including such biggies as GM and Ford, have begun offering employees and/or retirees the choice of a lump sum.

The reason: employers are increasingly looking to "de-risk" their pension plans. The idea is that if more participants accept lump-sum payouts instead of monthly checks for life, companies can cut their pension costs and reduce their long-term liabilities.

But while de-risking may be the right move for a company, the question for you is whether you're better off locking in payments for life or accepting a bundle of cash that you can invest and draw on throughout retirement.

Related: My employer got rid of its 401(k) match. What now?

There's no correct answer. The right choice depends largely on your situation, including how long you think you're likely to live, how much you value assured monthly payments, how confident you are about investing a large stash and what other retirement resources you can rely on.

In short, neither I nor anyone else can definitely say which option is best for you. By asking yourself the three questions below, however, you should be able to come to a decision that makes the most sense.

1. Do you need more guaranteed income than Social Security will provide?

With Social Security, you'll already be getting a monthly check for life, adjusted for inflation at that. If those payments are enough to pay for all or most of your essential living expenses, you may prefer the flexibility of rolling the lump sum into an IRA and then tapping it as you need extra cash.

But if Social Security doesn't cover as many of your everyday expenses as you'd like -- or you desire the extra measure of comfort that monthly pension payments can provide -- then the lifetime annuity income might be more attractive.

And, in many cases, a pension plan may pay 10% or more than what you could get by taking the lump sum and buying an immediate annuity from an insurance company.

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One reason is that insurers, unlike pension plans, must make a profit on their annuities. Insurers effectively lower their payments to reflect the fact that healthier people are more likely to buy a lifetime annuity. Pensions do not make that adjustment.

Insurers base their payments on actual life expectancies, resulting in lower payments for women since they generally outlive men. Pensions, however, are required by law to use unisex rates, which can make them an especially good deal for women.

But if you go with the pension annuity, there is the possibility that your company could run into problems and default on its promise to pay. Should that happen, however, the Pension Benefit Guaranty Corp. would cover you, although the maximum it will pay is just under $56,000.

Lately, some companies have been contracting with insurance companies to provide their pension's annuity payments. In such cases, it's unclear whether PBGC coverage applies if the insurer fails to make the payments and the pension plan isn't around to pick up the slack.

But at the very least, notes Thomas Finnegan a principal at the Savitz Organizaion and president of the American Society of Pension Professionals and Actuaries, you would still qualify for coverage up to the limits offered by your state insurance guaranty association.

Remember too that most corporate pensions don't increase their payments with inflation. So if you don't have other assets you can depend on for capital growth to help maintain your purchasing power, you may want to set aside a portion of your pension payments in the early years to provide a cushion later on.

2. Do you have enough saved in 401(k)s, IRAs or other accounts to meet emergencies?

No matter how good a deal a pension's annuity may be compared with what an insurer would pay, taking it may not be a smart move if doing so would leave you with virtually no assets to fall back on for unanticipated expenses.

So if your company pension represents virtually all of your retirement wealth, you may want to consider taking the lump sum and moving it to an IRA.

The challenge then is investing that money so it can generate sustainable retirement income -- ideally at least as much as the pension annuity pays -- without too big a risk of running through the lump sum too soon.

Related: Tips on planning for your retirement

That can be much tougher than you think. Once you get beyond 15 to 20 years or so into retirement, the chances of a relatively conservative diversified portfolio matching the pension annuity's payments begin to drop off steeply.

It's a bit easier for a retired couple to match the payment of a "joint-and-survivor" annuity that pays as long as either spouse is alive, since the annuity payment is lower to reflect the higher chances of at least one person being alive. But investing a lump sum to fund a retirement that could easily last 30 or more years requires skill and attentiveness -- and even then a market setback or lousy returns could deplete the portfolio early in retirement.

Keep in mind, too, that if you roll the lump sum into an IRA and begin withdrawals before age 59 ½, you would likely face a 10% penalty in addition to regular income tax.

That said, there's also a potential upside to investing the lump: You'll have access to that money as long as it lasts, as opposed to the annuity, which promises only monthly payments. And if the markets do well, you might be able to draw more from the lump than you would have gotten from the annuity, and even have money left over for occasional splurges or to leave to your no doubt incredibly worthy heirs.

3. Would guaranteed income and a lump sum be more appealing than just one or the other?

For many people, a compromise may be the answer -- that is, combining the security of lifetime payments with the flexibility of a lump sum.

The best way to do this would be to direct the pension plan to split your benefit, giving you say, half as an annuity and the rest in a lump sum that you would move to an IRA. That way you could take advantage of the pension's generally favorable annuity rates and still have ready cash for emergencies and such.

Unfortunately, even pensions that allow you to pick an annuity or lump sum usually restrict you to an either-or choice.

Earlier this year, the Treasury Department proposed new regulations aimed at increasing the number of plans that would allow people to split their benefit between an annuity and a lump sum. But even if those regs become law, there's no guarantee companies will amend their pensions to allow it.

Related: Make your retirement savings last

So, for now at least, you'll probably have to take the lump, roll it into an IRA and then use part of the proceeds to purchase an immediate annuity from a private insurer. Just be sure that you keep that annuity within the IRA to preserve its tax-advantaged status.

The downside to this approach is that the combination of smaller insurer annuity payments and low annuity payments generally because of today's low interest rates makes it harder to duplicate the pension's monthly payments than if you simply invest the entire lump on your own.

On the plus side, by splitting up your pension this way, you still have access to whatever size lump sum you roll into your IRA, and even if that money should run out, you'll still have the insurer's annuity payments coming in the rest of your life. By contrast, if you opt for a lump sum only and the dough runs out, you'd be left with just Social Security.

As you've no doubt surmised, this is hardly a simple decision. So if you're talking about a sizable benefit, you may want to consider having an adviser crunch the numbers on different scenarios. And even then you've got to be careful, as an adviser may stand to make a lot more money if you take the lump and let him invest it than if you go with the monthly payments. To top of page



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