Lump Sum Vs. Annuity

Key Points

  • If you have a defined benefit plan, you’ll likely face a choice at retirement between taking a one-time lump-sum payout or receiving a monthly payment the rest of your life.
  • Here we take a look at some important factors to consider if you’re faced with this decision.
  • Helpful information for anyone with a defined benefit pension plan who is nearing retirement.

Does your employer offer a traditional defined benefit pension plan that guarantees you a monthly pension payment for life? If so, congratulations are in order—such plans are becoming scarce these days. The trend toward 401(k)s, 403(b)s and other defined contribution plans means that more and more workers must rely on their own savings and investments to supplement their retirement income.

However, with a defined benefit plan, you'll likely face a challenging choice at retirement: whether to take a qualified one-time lump-sum payout—which can be rolled over directly into a traditional IRA—or to receive a monthly annuity payment for the rest of your life or, in some cases, even longer.

The decision becomes even more perplexing when your annuity payout options include:

  • Single life payment. This is usually the highest monthly amount.
  • 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 settle for a lower monthly payment to make sure your surviving spouse gets monthly payments for his or her life that are equal to 50% of your original annuity.
  • 100% joint and survivor. You get an even lower monthly payment, but in return, your surviving spouse gets 100% of your annuity in monthly payments for his or her life.

Your choice can have major financial implications, so it's a good idea to consult with a professional. But here are some important factors to consider as you work your way toward a decision.

Life expectancy

The simplest analysis compares the monthly annuity payment offered to what you could generate yourself by investing the lump sum at a similar level of risk. Key to this analysis is an assumption about your life expectancy. As a general rule, those people with good reason to believe they'll live well beyond the average life expectancy will likely find the annuity option more attractive, while those who don't expect to live beyond the average may find more benefit from the lump-sum option. There are many other factors to consider, of course, and we'll get to those a little later. For now, let's talk about life expectancy.

Imagine that at age 65 your company offers you a single life annuity of $2,000 per month for life or a lump-sum payment of $300,000. At first blush you might think the annuity is the clear winner, since $24,000 per year ($2,000 x 12 months) amounts to an annual rate of 8% on $300,000 ($24,000 ÷ $300,000 = 8%), and 8% is hard to get without taking on significant risk.

In order to do an 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 interest during retirement, leaving a zero balance) with built-in assumptions about how long you will live.

If you assume a life expectancy of 18 more years at age 65, then the annuity's internal rate of return is really only 4.16%. In other words, if you drew down $24,000 per year in both interest and principal on your $300,000 lump sum, you'd only need to earn an annual return of 4.16% to make it last for 18 years. In fact, the $300,000 would last 12½ years even with a 0% return ($300,000 ÷ $24,000 = 12.5).

Of course, the longer you live beyond your actuarial life expectancy, the better the annuity deal becomes. You would also have the convenience of a hassle-free monthly check. For example, assuming you receive a check for $2,000 at the beginning of each month and live 25 years to age 90, your annual compounded rate of return would be 6.61%. And if you live 30 years, to age 95, the annuity's yield to maturity jumps to 7.31%—not a bad rate when compared to current high-quality bond yields of similar maturity.

Obviously, if you chose a payout based on your own life expectancy with no survivor benefits and you died after the first year, it would be a pretty good deal for the insurance company.

TIP: Be sure to use a reasonable estimate of what your lump-sum investment might earn. We think a conservative portfolio of 20% equities, 50% bonds and 30% cash could grow 3.3% on average annually over the long term. Double that equity allocation to 40%—a riskier portfolio—and our 20-year estimate is still just 4.2%1 per year, much less than the annuity’s total return in the 30-year example above.

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 income, etc.), an annuity may be less attractive. And, because you wouldn't

    necessarily need to tap the lump sum for current expenses, you could leave it to grow for future use or include it in your gift and estate program.

  • Health. The longer you live, the better off you are with the annuity. If you believe your life expectancy may be below average, a lump sum becomes more attractive. (If you're married, you'll want to take your spouse's potential longevity into account as well.) Remember, by choosing an annuity, you're trading an asset for the promise of lifetime cash flow. By choosing the lump sum, you retain both the asset and the ability to generate income.
  • Risk. In retirement, reliability of cash flows is extremely important. There's something to be said for a steady monthly check regardless of what's happening in the markets. First, make sure you're comfortable with 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 pension participants, but the protection is not unlimited.) Then, consider the advantage of leaving the risk of investment performance to others rather than taking it on 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 hedge against inflation. Of course, doing so would involve taking on some market risk.
  • Convenience. Again, there's something to be said for having a monthly check automatically arrive in your bank account—especially if you plan on doing things besides managing your portfolio during your retirement (such as traveling). Even a bond ladder takes some expense and effort to manage, particularly if you're looking to generate a monthly check. You could pay a money manager to implement a total return strategy that generates income from your portfolio if you couldn't or didn't want to do it yourself, but that's essentially what you're doing with a fixed annuity. Keep in mind, managing a lump sum for retirement income takes careful planning, budgeting and discipline.
  • Cost comparison. Managing a lump sum yourself means incurring investment costs (management fees, transaction fees, etc.). Such costs are already factored into the annuity option. It can pay to do some cost comparisons here. You may want to shop around and see what kind of fixed annuity you could purchase from a high-quality, low-cost provider for an equivalent lump sum, and compare it to what your pension plan is offering.
  • Taxes. If you opt for a lump-sum payout, you can roll it over to a traditional IRA and continue to defer taxes. Receiving a monthly check, by contrast, provides you with immediate taxable income. Consult your tax professional about your specific circumstances.
  • Gift and estate planning. Unless you choose a term certain or survivor benefit option, your annuity ceases when you die. A lump sum, however, could provide your heirs with additional resources. Be sure to factor your gift and estate planning goals into any lump sum versus annuity decision.

What about both?

You might choose to take a lump sum and allocate a portion to a high-quality, immediate fixed annuity. Ideally, you'd annuitize as much of your essential fixed expenses as possible and use the rest of your portfolio for discretionary spending.

A reliable, fixed cash flow during your retirement years, even at a modest level, has a number of benefits. It can:

  • Boost your chances of maintaining your desired standard of living.
  • Help you avoid the need to liquidate assets at the worst possible time, such as during a bear market.
  • Help you to sleep better at night as you enjoy your "golden years" (especially the early years, when you're likely to be more active).

 Find a local branch or call 877-673-7970 to schedule a one-on-one discussion with a Schwab investment professional.

1. Source: Schwab Center for Financial Research Model Portfolio Estimates. Forward estimates contain certain risks and uncertainties. There can be no guarantee of future performance.

Charles Schwab & Co., Inc. distributes certain life insurance and annuity contracts that are issued by non-affiliated insurance companies. Not all products are available in all states.

Contract guarantees are subject to the claims-paying ability of the issuing insurance company.

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.

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

Category: Annuity

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