Your Pension Payout: Annuity or Lump Sum?

At last! You've served your time, building up your pension benefits by consistently squirreling away a portion of your paycheck into the company savings plan and tending it wisely through the years. Retirement's finally here, and now you have a gut-wrenching decision to make: how to take the money. And it's a decision not to be taken lightly; after all, at stake is likely the bulk of your retirement wealth. Since most choices open to you are irrevocable, if you choose incorrectly you're stuck with the consequences for the rest of your life. For those reasons, you'll probably want to have an experienced financial planner or accountant help you run the pertinent numbers to determine what's best for you, as well as keep you from being tripped up by the tax laws. Here are some things you'll need to consider:

Should you take your payout as a lump sum or as an annuity? If your only company retirement plan is a pension, the likelihood is that this decision has already been made for you. That's because most pensions pay benefits only in the form of a monthly annuity; in other words, you'll get equal monthly payments for the rest of your life. Very few remaining pensions allow employees to take a lump sum instead. You're most likely to face this choice if your retirement package includes a profit sharing savings plan or 401(k). Though such plans usually pay benefits as lump sums, your company may allow you to convert your account balance into an annuity. And even if your savings plan requires you to take a lump sum, you can always use the money to buy an annuity from an insurance company.

The annuity is guaranteed to last for the remainder of your life. On the other hand, even with a moderate inflation rate of 5% or so, fixed monthly payments will decline in purchasing power as time passes. For instance, a 5% annual price increase will halve the real value of your checks after only fourteen years. However, if you take a lump sum, you could put a portion of the funds into growth investments to preserve your assets' purchasing power. Additionally, if you're thinking of leaving money to your heirs, a lump sum payout might be beneficial.

In converting your benefits to a lump sum, a pension administrator calculates the amount it would take to pay you a monthly check for the rest of your expected life, as determined by actuarial tables (which show the average probable length of remaining life expectancy for people of different ages), with the assumption of a particular rate of return over time. But pension payments stop at your life's end (or the life of your surviving spouse), not at the end of the actuarial life expectancy that's assigned to you at retirement. Thus, an annuity could be a bargain - if, of course, you manage to live longer than average. A lump sum would be more advantageous if, unfortunately, you die shortly after your retirement party. So, for the sake of practicality, if you're generally chronically ill, it might be wise to consider taking a lump sum; conversely, if your or your spouse's heritage contains quite a bit of longevity, you could possibly lean toward the annuity.

It's important to note that in calculating lump-sum conversions, employers use unisex life expectancy tables, which understate women's life expectancy. Therefore, with all other factors being equal, that makes an annuity a better financial deal for a woman than for a man. Interest rates can also determine whether a lump sum or an annuity is more advantageous. The higher the rate the plan's actuaries assume that it can earn, the smaller the lump sum that's needed to pay the benefit. For example, in the mid-1980s, when interest rates were around 10%, a pension of $1,000 per month for a 60-year-old man translated to a lump sum of roughly $93,000. More recently, when interest rates were in the region of 6%, the same benefit produced a lump sum of $128,000.

Most pension managers assume a conservative interest rate at the beginning of the year and stay with it until rates are determined again the following year. Thus, in a year of rising interest rates, a lump sum offered by your plan late in the year could be suspiciously large. One simple way to tell would be to ask your life insurance agent how large an annuity benefit you could buy with the lump sum that your pension is offering. To be competitive, insurers must vary their interest-rate assumptions frequently to match prevailing rates in the marketplace. Therefore, if interest rates are rising, you may be able to obtain a higher monthly payment from an insurer's annuity than from your company pension.

The most common types of annuities are life income, which pays you a certain monthly amount until your death; life income joint and survivor, which assures that if you die first your spouse will continue to receive a certain amount until he or she dies; and life income and period certain, which pays benefits for your lifetime or for a specified period - whichever is longer. The option you choose will affect the size of the monthly checks that you'll receive. Life-only annuities pay the largest pension amounts but are necessarily cut off at your death; the other options continue to pay your beneficiaries at the cost of reducing your income by 10- to 15% during your lifetime. However, one possible method of gaining the advantages of both scenarios would be to select the life-only option and in addition to it buy a life insurance policy. In this manner, when you die and the pension payments cease, the insurance benefits will then provide continued income for your spouse. But be careful if you decide to use this option; it must be done correctly. Under federal law, a married person is prohibited from choosing the life-only option without the written consent of his or her spouse. So, you'll need your wife or husband's approval in order to implement this financial approach. In doing so, it's wise to obtain a notarized waiver of the joint-and-survivor option from your spouse.

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