Lump Sum vs. Annuity: Which Is Better?

Does your employer offer a traditional defined benefit pension plan (DB 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 more and more workers must rely on their own savings and investments to supplement their retirement income.

Even with a DB plan, you'll likely face some alternatives. Many pension plans offer a choice at retirement: take a qualified lump sum payout—which can be rolled over directly into a traditional IRA—or receive a monthly annuity payment for the rest of your life.

The decision becomes even more perplexing when 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 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 life equal to 50% of your annuity.
• 100% joint and survivor. An even lower monthly payment, but your surviving spouse gets 100% of your annuity payment for life.

It's a good idea to consult with a professional planner on these issues, but here are some general points to consider as you weigh your options.

Comparing an annuity to a lump sum
The simplest analysis compares the monthly payment offered to what you could generate yourself by investing the lump sum at a similar level of risk.

For example, let's say 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.

Not so fast
In order to do an apples-to-apples comparison, however, you should keep in mind that the annuity takes a total return approach (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 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 would only need to earn an annual return of 4.16% to make it last 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. 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 compound rate of return goes to 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 died after the first year, it would be a pretty good deal for the insurance company.

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 no matter 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 Guarantee 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 will lose purchasing power over time. A lump sum could be invested to include a prudent allocation of stocks and/or TIPS (Treasury Inflation Protected Securities) to hedge against inflation. Of course, this involves 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 in retirement (like traveling…a lot). Even a bond ladder takes some work and expense to manage, especially if you're looking to generate a monthly check as part of a total return strategy. You could pay a money manager to implement a strategy for generating 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 yourself 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, as compared to what your pension plan is offering.
• Gift and estate. Unless you choose a period 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 vs. 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 would 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 significantly boost your chances of maintaining your desired standard of living.
• It helps you avoid the need to liquidate assets at the worst possible time, such as during a bear market.
• It can give you financial peace of mind and help you sleep better at night as you enjoy the "good years" (especially the early years, when you're likely to be more active).

Rande Spiegelman, Vice President of Financial Planning, Schwab Center for Financial

Read more tips from Charles Schwab in money.gather.com