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Choosing Between A Lump-Sum Distribution Versus An Annuity from Your Employee Pension (Ridgewood Retirement Income Planning Guide)

Do you work in a position that offers you retirement benefits funded by a traditional defined benefit plan? If so, consider yourself fortunate. Defined benefit plans offer attractive benefits for employees and were once far more common than they are today. 

However, since they often cost employers more money in employer contributions than today’s more popular defined contribution plan counterparts like the 401(k) plan for private for-profit companies and 403(b) plans for non-profit organizations and government employees, they have gradually become much less common than they used to be in the last three or four decades.  In many cases, government workers and certain larger companies with union employees still offer their employees retirement income options funded by their defined benefit plans.

The benefit of having a defined benefit pension plan, if your employer offers one, is that under this type of pension, it is your employer (and not you) who has the responsibility for contributing to a plan in a way that guarantees to give you a certain level of benefits at retirement.  Your benefits are usually based on your years of service and your income while you were employed by the company or employer.

When somebody who is a participant in a Defined Benefit Pension Plan (DB) is about to retire or offered a voluntary retirement package, they are often presented with the option to take their benefit as either an annuity (monthly distributions) for a certain period or as a lump-sum.

Like many choices in life, few people are equipped to appreciate the trade-offs involved between choosing a lump-sum which pays out the entire balance upfront (or into a rollover IRA) or the option to select an annuity stream which spreads out the amount you have earned through your service into monthly payments released to you over many years. 

To make a decision like this property requires experience, thought and planning.  Unfortunately, the choice is a complex one in which it is challenging to appreciate all the factors and trade-offs that need to be considered.  When you are in this situation, it may be a good idea to seek out professional guidance because the stakes are quite high!

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The choice can be complicated by a number of trade-offs that have to be weighed carefully, in many cases the best way to decide would be to actually create a detailed financial model that actually projects the cash flows under various options and assumptions and matches up those choices to your own personal situation and life priorities.

This type of analysis is called financial analysis and is not to be taken lightly.  In fact, choosing the “right” option for you could literally mean tens of thousands if not hundreds of thousands of extra dollars in your pocket over time.  On the other hand, picking badly could really diminish your future income, or in some extreme cases even leave you without a comfortable retirement.  Read on below as we describe the process of reviewing your likely options and provide valuable insights on a sound framework you can use to make an intelligent choice.

Unfortunately, there is no single universal standard for how your choice will be presented to you.  Each pension plan frames the choice in slightly different ways.  In most cases, you will receive some sort of document or brochure from your plan explaining the choice you have to make and how to make the election (and by when).  Its very important if you are given such a document to save it and review it carefully.

Also remember that these type of documents (also known as disclosures) are often drafted by lawyers to meet technical and legal requirements.  Its not uncommon for these types of documents to be lengthy and contain some legal “fine print.” If you don’t understand exactly what it says or the choices you have to choose from then this is probably a sign that you might benefit from consulting with a highly qualified professional who can review it on your behalf and explain it to you in plain English.

What is the difference between a lump-sum and an annuity?  In the case of the lump-sum, you will be given the ability to get all the money you are owed in one payment.  In most cases, this means that you will tell the plan to “roll over” this amount of money into your own IRA (individual retirement account). 

By taking your lump-sum as a rollover into your IRA there are multiple benefits: 1.) You or an advisor can invest this sum and if it is done competently, your money can grow and perhaps give you a lot more income over time than the annuity you are being offered 2.) Rolling over the lump-sum into an IRA prevents you from having to pay any taxes upfront and therefore can allow your investments to enjoy tax deferred growth for quite a while 3.) Instead of being reliant on the solvency of the pension plan many years from now, by taking the lump-sum you no longer have to worry about whether the plan will have run out of money down the road.  On the other hand, the main drawback of the lump-sum option is that you have to assume some responsibility and if you do a bad job you have to live with the result.

Taking the annuity option means that you are leaving your money in the hands of the pension plan for the rest of your life. It also means that instead of getting your money and then investing it yourself, you want your plan to do it for you and keep the responsibility.  Instead of that lump-sum now, you are asking them to pay you what you are owed over a long-period of time.  In theory if the plan is taking on that responsibility, they will simply calculate what a mix of “safe” investments will give them over time (given very low interest rates today on "safer" bond investments, annuity payments are lower than they used to be).   The plan then calculates your monthly benefit payment low enough to make sense for them given the return that they project to generate over time and your expected lifespan.

Another complicating factor is many companies who offer you a choice between a lump-sum and an annuity then also give you multiple types of monthly payment options during the annuity selection process.

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​Some of the most common options to the annuity monthly payments to you are:
  1. Monthly payments based on a single life – typically the life of the employee who is retiring.  In this option, the pension will pay you a certain amount each month for so long as you live.  In this option, monthly payments stop when the person dies.  This means no benefits for the survivor and anyone unlucky enough to die much sooner loses their payments without ever recovering what they are owed and, theoretically, someone far outliving their projected life expectancy would benefit by collecting payments for far longer than originally expected.  Think of this aspect of annuity payments as the lifespan lottery.
  2. Monthly payments based on single life but with a minimum term – in this case, your payments would likely be a bit less than option one, because if you die prematurely, your beneficiaries are still guaranteed to get payments for at least a minimum period that is specified at inception
  3. Monthly payments based on reduced joint and survivor benefit – In this option, the monthly payment is typically lower still, but in case of the death of the original covered person, their survivor (usually a named spouse or partner), gets a reduced level of month benefits (often 50% but could be a bit higher or lower) as compared to the payments level provided while the first person was still alive.  This reduced level of benefits would then continue as long as the second person was still alive, guaranteeing them at least some income.  Note that social security is essentially a type of monthly annuity that is also based on joint and survivor because the widow and/or minor children of the deceased can continue to receive survivor social security benefits at a reduced level.
  4. Monthly payments based on 100% joint and survivor – In this option, the monthly payment is typically the lowest of all of these four options. However, the payment stays at one set level and continues at the same level for so long as either spouse or partner is alive.

Note that between the lump-sum versus the annuity and then even among the various annuity payment types above, there are trade-offs involved.  Whether one or the other is better in your own individual circumstances depends on how much they are offering for you to get upfront versus how much each monthly option will pay you and for how long if you were to chose to receive the stream of payments overtime.

Most people facing such a momentous choice are likely to be better off consulting an experienced financial advisor like Ridgewood Investments who has experience helping clients make complicated financial choices that could affect their retirement security and that of their families over many years.  Typically, when analyzing a choice like this one of choosing between a lump-sum and an annuity, the experienced investment advisors at Ridgewood Investments will use a tool such as Excel, a spreadsheet program made by Microsoft, or other sophisticated cash flow or financial planning software to model various scenarios.

See below as we explain the factors that would be involved in a proper analysis.

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The first factor that must be considered is your personal circumstances:
Life expectancy:

How long is the annuitant (or both if joint) forecast to live.  Outliving your funds is a risk that can be faced by retirees. Family medical history and lifestyle influence this situation. A married couple at 65 has a 50% chance one spouse will live to 92. Women must take this into special consideration since they tend to live longer on average than males.  On average, a 65-year-old man will live to 84 and a 65-year-old woman to 86.5.  However, improvements in medicine and lifestyles are expected to continue to increase average life spans in the coming decades.

Marital Status:

When someone is married and they want to leave income for their surviving spouse that person would have to take into consideration what types of annuity distribution plans they have available that can accommodate that, since not all companies offer all the annuity distribution options each plan must be analyzed individually.

Aging:

Decision-making abilities tend to decline with age, which can leave people more vulnerable to financial abuse, fraud and unsatisfactory investment decisions that could wipe out retirement savings.

Spending habits:

Someone who’s about to retire should analyze if they will want to live as they did when working, or if they might want to spend a little more on traveling and hobbies, or maybe spend a little less by reviewing and creating a budget or perhaps downsizing and relocating to a less costly area. They should also recognize if they are conscious spenders or if they are more impulsive because their personality type and tendencies can have a directly influence on which choice may be more prudent for you.

After this it is necessary to compare other risks:
Inflation:

Annuity: unless the annuity payment carries a cost-of-living adjustment (COLA), meaning payments go up over time, purchasing power will be lost over time.  This is one of the major drawbacks of annuities.  And even if your option includes a COLA, this means that your upfront monthly projected payment will be lower still than if the COLA had not been offered.

Amount of the Lump-sum:

If invested properly following a consistent strategy over a long period of time, including a prudent allocation to equities and bonds and perhaps even TIPS (Treasury Inflation-Protected Securities) it could help the amount of assets that you receive in a lump-sum to have a better chance of keeping up with inflation or perhaps even growing much more than inflation.

How well you can do with the lump-sum depends on how skilled you are at investing the money to maintain its value and grow and generate passive income for you.  But this depends in part on markets and economic health and in part on your ability to understand and research and manage your money intelligently.  Note that if you do take a lump-sum, putting the money into ultra-conservative investments is not likely to keep pace with inflation.

The lump-sum amount they will offer you is itself based on a complicated formula.  In a nutshell in order to choose intelligently, you have to compare the amount of the lump-sum and what investments you would be confident to make with it and then project what type of income those investments are likely to generate for you over time (remember this would be a projection not a certainty) and then compare this to the annuity payment options to see which one would leave you better off over the long-term as well as better fit with your goals and personal situation. This is a critical but by no means simple exercise to do thoroughly and properly.

Taxes are another important factor:

Lump-sum: To avoid large and immediate taxation of the entire amount, it is typically rolled over into a traditional or rollover IRA set up to receive these assets from the DB pension plan. And as of 2020 under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, the age that participants need to start taking distributions was pushed back from 70 ½ to 72.  Potentially giving those who do not need the income to start immediately to defer and grow the lump-sum for a few more years before starting to take regular distributions.

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Company health/credit risk:

When accepting the annuity monthly distributions from an employer, the company’s financial health is a very important factor, because if the business fails the plan might eventually run out of money to meet all its promised obligations to its various beneficiaries and stakeholders.  Indeed just ask the employees and retirees of such formerly stalwart companies such as Kodak or Sears and you will realize that this risk is not merely academic.

Fortunately, all retirement plans have some filing and disclosure obligations under a federal law called ERISA.  ERISA is an acronym for the Employee Retirement Income Security Act which outlines rules, regulations and protections for retirement and pension assets.  Under this law, every pension plan has to file an annual Form 5500 filing and these can be accessed by the public using a website like www.freeerisa.com.  Form 5500 filings disclose the plan’s financial condition. Part III of Schedule B of these filings lists the plan’s current assets, liabilities and percentage of funding. This information can be used to estimate the solvency of your plan which is an important consideration in the choice of whether to take a lump-sum or an annuity.

Note that pension plans do have a federal agency that insures plans.  This agency is called the the Pension Benefit Guaranty Corporation.  In cases of failed single- or multi-employer pension plans the PBGC would step in to guarantee payments.   As of 2020 the PBGC insures plans that cover over 35 million Americans who participate in such plans.  Given the PBGC’s available resources, in any major economic disruption, the PBGC would likely only have enough resources to guarantee a limited number of failing plans.  Therefore, those opting for annuities from weaker plans might still have risks to consider if the PBGC were to run out of funds unless Congress or the Federal Reserve Bank decided to back up the PBGC with the full faith and credit of the United States.

Projected Investment Returns

For some people, especially those who may be less experienced in managing money or finances and lacking the right advice, the lump-sum option can be outside their capabilities to manage properly.  For these people, having immediate access to a large amount of money could make it easy to mismanage and invest it poorly, perhaps leading them to irreversibly squander a life time of accrued benefits.

This risk is not just theoretical, just like lottery winners and athletes, there is evidence that certain people are poorly prepared and make bad decisions when they receive larger sums without proper preparation, advice or ability. According to a 2016 Harris Poll of recent retirees, approximately 21% of retirement plan participants who took a lump-sum depleted it in 5.5 years probably due to a combination of poor planning, excessive spending and unwise investment decisions.

Even if that is not the case, the challenge of investing well and then managing through markets that occasionally experience volatility can be daunting.  Making emotional decisions can sometimes cause people to start dabbling in market timing instead of long-term investing to get themselves into hot water.

On the other hand, the lump-sum rollover option also gives maximum investment flexibility and investment options. As we discussed in our recent articles on passive income strategies:

smart investors or their advisors can use the flexibility offered by the combination of the lump-sum and rollover option to create a homemade annuity stream that could end up exceeding the annuity stream offered by your employee pension.

One of the ways to do better with your lump-sum is to invest in good growing stocks and dividend paying companies, but another option is to also use the flexibility of a self-directed IRA for part of the lump-sum proceeds to also invest in private assets such as private debt and private real estate that can generate regular distributions of 6 to 8% on that portion of your money.

A Hybrid Option – The Best of Both Worlds?

So far, we have been comparing and contrasting the lump-sum versus annuity options to show the distinctions for explanatory purposes.

However, if you like the idea of having both an investment portion for greater growth and an annuity portion for safety, these is also a way to use the lump-sum option to create a hybrid solution that can give you any desired mix between the two choices.

The way that this could work is to first take the lump-sum and rollover that lump-sum into an IRA account at a reputable custodian.

The next step would be to divide those IRA assets into two or three different IRA accounts (perhaps including a self-directed IRA that, as mentioned above can open up your investment options into income producing real estate and private debt also backed by real estate).

In this example, one of the IRA accounts can be invested in growing stocks and bonds and dividend paying stocks.  A second IRA account could potentially be invested in private income generating real estate and loans on that real estate.  The final IRA account can be invested in one or more low cost third-party annuities (as we discuss in our detailed article on what you need to know about annuities and their secret pitfalls, you have to be careful as many annuities are high cost instruments loaded with fees) or in a strategy that can allow you to “create your own annuity." The amount that you put into each bucket is flexible and can be increased or decreased to match your individual situation, preferences and needs.

All of these accounts can then start paying you a monthly income whenever you decide to take it and if it is done correctly, this monthly income can be managed to try and beat (over time) the annuity income you would have received from the original annuity option that they gave you upfront.  It can also be designed to have a built in cost of living adjustment to keep up with or exceed inflation.

Note that is hybrid option is not limited to those facing the choice between a lump-sum and annuity from your employer's pension plan.  Even if you have contributed to and accumulated substantial balances of $500,000 or more in your workplace 401(k) or 403(b) plans, you can also rollover these balances into individual IRA accounts and take advantage of our hybrid approach in the same manner as discussed above.

​Ridgewood Investments - Your Highly Experienced Pension Decision Advisor


Remember, that the choice you face may be one of the most important decisions you will ever make in your life.  Once the choice is made to take an employer annuity or the lump-sum, there is potentially no going back if you don't like what you end up with down the road, and you will have to live with that choice for the rest of your life.  It is a choice that could impact not only your own retirement security but likely also that of your spouse and even potentially the assets available to support your children and other family members.

Given the importance and stakes involved, it is prudent to carefully weigh the pros and cons and if any guidance is needed Ridgewood Investments is here to help.  We can thoroughly but efficiently review your available options, create any necessary financial models and frameworks, and explain your options in easy to understand terms.

In addition, if you do decide to take a lump -sum, Ridgewood can help you to set up all your IRA accounts property and assist you to make the transfers and deposits of your lump-sum into your IRA account (s) effortless and convenient.  Moreover, when it comes to investing the lump-sum intelligently and in a way that will last you for your lifetime and serve your goals, having an experienced investment advisor like Ridgewood Investments to manage your accounts, be your financial advisor, and properly guide you on your investment strategies can really make a big difference towards maximizing the benefits and income distributions that you can enjoy over time from your lifetime of hard work!

About the Author

Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.

Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.