While the days of big, plump retirement pensions are dwindling, I still have regular conversations with individuals who have pensions through their workplace. This is a tremendous benefit generally providing a guaranteed stream of monthly payments (an annuity), and may include payments for a spouse or beneficiary.

But in some cases, receiving an annuity payment may not be the best option. In this article I’d like to explore the pros and cons of annuitizing your pension, versus another option that’s typically available as well: the lump-sum payment.

Benefits of the monthly annuity option

When you retire with a pension, the most frequently chosen option is to start receiving monthly payments, rather than taking a lump sum. These payments can come in a variety of ways, to a variety of people. Single Life Payments will typically be the highest monthly amount, but these payments stop as soon as you die. As you make your payment available to a surviving spouse or beneficiaries, such as with Joint Survivor Payments or Single Life with Term Certain, your monthly payments decrease.

Your pension may have several implicit guarantees backing it. If your pension is provided by a private employer, then they are guaranteeing at least a portion of your pension. Additional guarantees may come through the Pension Benefit Guaranty Corporation, a company that backs up failed pension plans due to insufficient funds. Public pensions, such as those for a public school teacher, may be backed by investment earnings on plan contributions, or possibly the taxing authority of the state or public entity.

The benefit of secure, guaranteed retirement income with a variety of payout options should not be underestimated. Studies show again and again that this brings tremendous peace of mind to retirees’ financial security.

Benefits of the lump-sum payment option

So with a variety of payout options and direct and implicit guarantees of your pension income, why would anyone choose a lump-sum payout? The lump-sum payout option might be preferable in at least two cases:

You don’t expect to live very long and don’t have a surviving spouse or children to take care of.

The expected return of the pension plan is far below a modest expected return in retirement.

Unfortunately, no one has a crystal ball to tell them exactly how long they’ll live. It’s important to remember that pensions make more sense the longer you expect to live. So if you retire at age 62 and only expect to live until you’re 70, a lump-sum payment is worth considering.

WIth an assumption of how long you’ll live, the expected return of the pension can be calculated to show you the expected rate of return of your pension over time. Following is a well written example from the investment management company Charles Schwab explaining how this should be calculated (the full article is linked here):

Imagine your company provides a pension, and offers you at age 65 a single life annuity of $1,625 per month ($19,500 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 $19,500 per year ($1,625 x 12 months) amounts to an annual payout of 6.5% on $300,000 ($19,500 ÷ $300,000 = 6.5%). You may conclude that 6.5% 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 6.5% “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 1.7%. In other words, if you withdrew $19,500 per year in both investment earnings and principal on your $300,000 lump sum, you’d need to earn an annual return of 1.7% on average through retirement to make it last for 18 years. In fact, the $300,000 would last a little over 15 years even with a 0% return ($300,000 ÷ $19,500= 15.4).

Source: Williams, Rob. “Lump Sum vs. Annuity.” June 28, 2019. https://www.schwab.com/resource-center/insights/content/lump-sum-vs-annuity-1

An important point here is understanding your pension’s internal rate of return. Again, a big assumption is life expectancy.

Another important assumption to understand is what to compare the internal rate of return to, in order to decide if your annuity option is a good deal.

In the example above, the expected annual return is 1.7% given the assumptions. The article goes on to state that a hypothetical conservative portfolio might expect to earn anywhere from 4% to 5% per year. In other words, assuming you lived 18 years in retirement, you could either receive your pension annuity payment which would effectively translate to a 1.7% guaranteed annual return, or you could take the lump-sum option, invest it, and potentially (no guarantee) receive a 4% to 5% annual return.

If this person lived 25 years into retirement (a longer life expectancy), the internal rate of return is 4.15%, which is a guaranteed return much closer to the conservative portfolio’s performance. On the other hand if this person lived 5 years into retirement, their internal rate of return may end up being negative!

I hope this has been a helpful review of the tradeoffs when considering annuity versus lump-sum pension payment options. Pensions are a dying breed, so to have one available to you is a huge benefit. To maximize its potential retirement value, it is worth determining your pension’s internal rate of return (among other considerations) before automatically choosing to annuitize.