Pension Planning: Lump Sum or Annuity?

Pension and RetirementIf a pension program is part of your retirement portfolio, you’ll eventually face a somewhat complicated decision: Do I take the lump sum, or do I instead stick with monthly payments? How you answer may have a profound effect on your retirement.

There’s no right or wrong answer here. The decision to take a lump sum or monthly payments will vary from person to person. I find that it’s a source of regular questions from the class participants who attend my retirement classes I teach at Cape Cod Community College and through the Falmouth Adult Education. Most of these folks are either heading into retirement or already in retirement and who want to get some help building out a retirement system.

You see, I never look at an investment choice as good or bad, but rather as appropriate or inappropriate depending on the individual investor’s situation. Things I consider are their investment objectives, their appetite for risk and drawdown, where they are in their financial lifecycle (accumulation or distribution), and other factors. I believe that every investor must understand the risks involved with their investment choices, so this week let’s dive deeper into the pros and cons of keeping your pension or rolling it into an IRA.

First, the popularity of pension plans in the private sector has steadily decreased ever since 401(k) plans first came to the market in the early 1980s. The liability and administrative cost of managing pension programs is more than many businesses are willing to accept these days. Many companies have closed their pension plans to new enrollees; others have shut them down altogether.

But that doesn’t mean pensions have disappeared. Teachers, government employees, and private sector employees continue to count on pensions to provide them with income in retirement, according to the Bureau of Labor Statistics.

When it comes to deciding whether to keep your pension or roll it over, you’re ultimately deciding between the security of monthly income according to the terms of the pension, or the freedom of being able to invest and spend money according to your needs. In other words, who has control of the asset.

A pension annuity is a steady stream of income that won’t change much from year to year, often times not providing a needed inflation hedge. With people living longer than ever in retirement, according to statistics by the Social Security Administration , having guaranteed income for life is no small feat and is certainly an essential form of financial security.

But over time the benefit of that regular income can diminish as the cost of living continues to increase, and as our financial needs change late in life. For example, if you need cash for a medical emergency not covered by Medicare or other medical insurance, you won’t be able to draw extra from your pension to help cover the gap. If you have another financial emergency, again, you’ll need to look for help elsewhere.

So, it’s important for retirees receiving annuities to maintain other, more liquid resources that can be counted on for unexpected expenses, such as cash in savings, an IRA or brokerage accounts, and home equity loans, for example.

One of the biggest reasons to abandon the pension and to take a lump sum payout is to get control over your money. Gaining control allows you to decide how to invest your hard-earned asset. The process includes rolling it over to an IRA through a trustee-to-trustee transfer. Upon transfer, design and deploy an investment and income strategy aligned with your investment and income goals. That plan must employ risk mitigation strategies.

It is important to understand how either action will affect your overall retirement plan. For many of us, a pension is only one part of our retirement portfolio. Social Security, other retirement savings accounts such as 401(k) or IRAs, cash savings and other tools may all be part of a retiree’s portfolio. If those other tools and investments cover your retirement income needs, a lump sum payout can provide you with additional flexibility in retirement that you wouldn’t otherwise have.

Make an honest assessment of your spending habits as you make your determination. If there’s a lot of uncertainty about your spending needs in retirement, you may discover that having the monthly annuity is a more secure option. Alternately, if you know you’ll need the money, this may be your best opportunity.

In advance of your decision, you should compare the implied return on your pension – the amount of money you can expect to receive through the course of your life – against the gains you might see from investing the lump sum payout in a dynamic risk-adjusted portfolio. Any investment decision must also include historical data to help you understand the behavior of your portfolio through years like 2001, 2002, and especially 2008. Depending on the outcome, it may be to your advantage to take that money and invest it, rather than relegating it to the expected returns promised by the pension fund trustee.

Additionally, we must make sure we understand the overall condition of the pension plan and the trustee which oversees it. Many of today’s plans are underfunded. The funding ratio of state pension plans in 2017 was only 70.2 percent, according to Wilshire Consulting. And that’s actually better than it has been. Still, that’s a big gap and cause for concern.

Trustees can and indeed have gone bankrupt, and some pension plans have been reduced or eliminated as a result. Remember Detroit? The Pension Benefit Guaranty Corporation (PBGC) was created by the federal government in the wake of the Employee Retirement Income Security Act of 1974 (ERISA) to help encourage and continue private pension programs, and it has stepped in when pension plans have failed.

However, the PBGC is chronically underfunded. In fact, the U.S. General Accounting Office (GAO) estimates that the PBGC’s exposure to future losses is nearly $243 billion. The PBGC has less than $100 billion in assets. That arithmetic doesn’t lend itself to a strong sense of security that pension plan recipients will receive guaranteed annuities no matter what.

When weighing your pension payout strategy, there may be a third option for you to consider. In 2016, the Internal Revenue Service (IRS) and the Treasury Department released new regulations that, for the first time, encouraged plan sponsors to offer a split distribution option. That is an option that enables pension plan recipients to split their benefits between a lump sum payment and a monthly annuity payment.

In the case of a split distribution, both your lump sum and your monthly annuity will be reduced, but for some pension plan recipients, this provides the best of both worlds. You receive some cash on hand to invest or spend, and a steady flow of income that you can count on throughout your retirement.

Folks, deciding how to handle your pension benefits is a critical step towards achieving financial freedom as you reach your retirement years. Now more than ever, make sure you seek out a retirement specialist who understands the importance incorporating both income and investment planning to ensure a sound retirement system for you and your family.

Be vigilant and stay alert, because you deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at

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