Should you take the annuity or the lump sum?

A number of our clients recently sought our advice after receiving a letter from their common employer (a large pharmaceutical company) presenting them with the choice of taking a lump sum distribution from their pension. After working with each of our clients and analyzing the offer within the context of their unique financial situations, we found that taking the lump sum was a potentially great option for some, a likely not so great option for others, and for many a definitive “maybe.” In this commentary, we provide a brief overview of the options usually presented in such situations, and demonstrate why there isn’t always a definitive answer as to the best choice. 

First, let’s review each option and their benefits and risks:

• Lump Sum: Receive a one-time payment today of qualified funds. We generally recommend that this payment be rolled into a qualified account (e.g., IRA, 401(k), etc.) so that it is not taxable until withdrawals are taken.
  • Benefits: Receive the funds today; be able to withdrawal when it is optimal for taxes and cashflow needs; opportunity for tax-optimization strategies and estate planning strategies; beneficiaries will receive balance of funds upon passing
  • Risks: Outlive the money due to investment returns being lower than projected or living longer than expected
• Annuity: Receive monthly payments for life, starting at a certain age, usually between 60-65.These payments typically do not change over time and they stop when the individual or couple (if survivor benefit is elected) pass away.
  • Benefits: Never outlive the money; consistent stream of income; no investment risk
  • Risks: Pass away prematurely and total benefit isn’t earned; inflation reduces purchasing power

Before we talk about how to choose, take a minute and think about which option you would choose if given the opportunity.  Do you like the appeal of receiving a lump sum today or of knowing you have a stable monthly income to rely upon in the years ahead?  What other factors or variables influence your decision?

We are fortunate to know our clients well and thus did not have to ask many of the “usual” questions: 

• What other income will you have in retirement?
• Is someone else, like a spouse, relying on this for their livelihood as well?
• What other funds do you have saved?
• What is your risk tolerance for investing the lump sum?
• How is your health?
• What is your family longevity like?

These questions highlight just a few of the key factors that influence such a decision. As you can clearly see, they also make it such that a simple calculator is ill-suited to answer these questions. The complexity arises from the necessity of understanding what assumptions to make regarding critical variables such as projected rates of return, longevity, tax rates, and then what we call the “flexibility premium.” Each individual’s personal financial situation dictates many of these variables and therefore changes the answer about what to do.

Below we summarize the key characteristics that separated our clients into each of these categories in an attempt to shed some light on how you can evaluate such a choice if ever presented with the option.

Take the lump sum.  Generally, the lump sum option appeared to be the best choice for our clients who are in their 40s and 50s, are on track to retire early, have saved and invested diligently over the years, and are in good health. This also was the answer for a couple of clients who had health concerns or a history of poor longevity in the family. The lump sum affords them a lot of optionality, which the annuity does not.  If they live a long time, great!  If they do not, their family will at least receive something versus nothing if they chose the annuity.

Take the annuity. Generally, taking the annuity appeared to be the best choice for our clients who are very close to retirement, have other investment accounts they could use for unexpected expenses, and expect to live a long time as they are in great health and have a strong family history of longevity. These clients have the greatest chance of outliving the lump sum and stand to benefit from having an income that lasts their lifetime.  We also recommended this option for a client who is risk adverse and would want to invest the lump sum very conservatively.

Ultimately, for many of our clients, our analysis and discussion revealed that both options had a lot of merit and that both could potentially work very well. As we outlined earlier, clients had to balance three risks:

• Risks associated with the annuity:
  • Passing away early. If you pass away before your mid-80s the numbers usually show the lump sum was the better choice.
  • Inflation and purchasing power. The monthly income for the annuity does not increase over time and therefore the amount you are receiving today will feel like it’s been cut in half over 25 years or so when making purchases.
• Risk associated with the lump sum:
  • Outliving your money, due to either long life or subpar investment returns.

We hope this was helpful and gave you some insight into the personalized analysis that goes into these and other types of decisions we work through with and for our clients. Even if you are not one who has this option, it is a good exercise. Given the different types of risk, which would you choose?  These answers can help you decide on how you invest, the types of insurance you choose and how much, and many other financial decisions.

As always, thank you for your time and please reach out with any questions or help you might need.  We would love to talk!