The Most Important Pension Decision You Can Make

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Whether it’s because their employer’s pension plan is terminating or they’re about to retire, one of the most common questions we get is whether to pick an annuity or lump sum payment from a pension plan. Choosing the annuity provides an income payout for as long as you (and perhaps your beneficiary) live. A lump sum gives you all or some of the money upfront. Either way, this choice is usually irrevocable and can have a huge impact on your retirement so here are some factors to consider before making your decision:

Do you have adequate savings for an emergency?

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If not, consider taking at least some of your pension as a lump sum. You don’t want all your money tied up in an annuity in case you need some cash in a crunch.

Do you have a mortgage or other debts to pay off?

Using a lump sum to pay off these debts can often free up more cash than the extra income you’d get from the annuity plus you’d save yourself some interest.

How much income would you need from the lump sum?

If you’re planning to withdraw more than 4% of the value of the lump sum, then there’s a significant risk of running out of money. On the other hand, if you need to withdraw less than 4%, there’s a good chance your money will grow faster than you’re taking it out and you’ll be able to leave some extra money for your heirs. Which brings us to…

How important is leaving assets to your hairs?

With an annuity, you can designate a beneficiary to collect the income for as long as they live after you pass away, but if your beneficiary dies before you, your heirs get nothing. On the other hand, you can make sure that someone other than an insurance company will always get your assets with a lump sum. Speaking of the inevitable…

What’s your life expectancy?

The longer you live, the better off you’re likely to be with the annuity. After all, it’s guaranteed to pay as long as you live but you could end up outliving the lump sum, especially if the investments don’t perform as well as you expected. The good news is that unlike life insurance, annuities generally aren’t medically underwritten so you can “cheat” by choosing the annuity if you think you’ll live longer than average. The bad news is that most of us have no idea what our life expectancy is. However, you can get a free estimate based on your family history, health, and lifestyle at Living to 100,

Are you worried about inflation?

Most annuity payments lack a cost-of-living adjustment so they won’t keep pace with inflation. This can be especially harmful the more you spend on things like energy and health care expenses, which tend to rise even faster than the general inflation rate. Of course, for the lump sum to beat inflation, it will need to be invested for growth.

How comfortable are you with investment risk?

If you’re an aggressive investor, you might be able to earn more by investing the lump sum than you would get in annuity payments. On the other hand, if you’re conservative, you’ll not only likely sleep better with a guaranteed annuity payment, but you can also rest assured that you’re probably not missing much in terms of what your conservative investments would have earned if you had invested the lump sum.

Would you be better off using the lump sum to purchase an immediate annuity?

Even if you decide to go with an annuity payout, you may want to shop around and see if you can get a better deal somewhere else. That could be a higher monthly payout or features like inflation protection or a cash refund option that your retirement plan may not offer.

What taxes and penalties would you owe on a lump sum withdrawal?

If you decide to go with the lump sum, that doesn’t mean you should necessarily take it out all at once. Withdrawing a large lump sum can push you into a higher tax bracket and you might also have to pay a 10% penalty unless you’re over 59 1/2 or you left your job the year you turned 55 or later. That’s why you may want to roll it into a retirement plan and then take it out over time.

Is there someone you can consult?

If you’re still unsure, it could be a good idea to talk with a financial professional who can help you crunch the numbers and think through the ramifications. This ideally would be someone who doesn’t have a stake in the outcome. Unfortunately, that precludes most financial advisors who are compensated by commissions or a percentage of the assets they manage for you, including potentially that lump sum payment. See if your employer offers unbiased guidance through a workplace financial wellness program or if there are financial planners in your area that charge an hourly, monthly, or annual fee.

As you can see, there’s a lot to consider in this choice. After all, it’s a decision you’ll have to live with for the rest of your life. Make sure it’s an educated one.

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