Pension lump sum vs. annuity

The choice some pension plans offer between a guaranteed monthly payment for life and a single one-time payout of the pension’s value.

What it means

Some defined-benefit pension plans let a departing or retiring worker choose between a lifetime monthly payment, called the annuity option, and a lump sum. The plan calculates the lump sum from the expected stream of payments using interest rates and life expectancy tables, so offers can change with interest rates. Annuity options often include a single-life version and joint-and-survivor versions that pay less per month but continue for a surviving spouse.

The annuity shifts investment and longevity risk to the plan, and private pensions are partly backed by a federal insurance program if the employer fails. The lump sum offers control, flexibility and something to leave heirs, but the retiree takes on market risk and the risk of spending it too fast. Rolling the lump sum directly into an IRA generally avoids immediate taxes.

Example

Suppose a plan offers either $2,000 a month for life, which is $24,000 a year, or a $300,000 lump sum. The pension pays the equivalent of 8% of the lump sum each year for life; withdrawing 4% a year from $300,000 invested would provide $12,000, though the lump sum could pass to heirs.

How it’s used

Retiring or leaving an employer with a pension
Comparing guaranteed income with investable savings
Planning survivor income for a spouse

Strengths and weaknesses

Strengths

Annuity provides predictable income for life
Annuity removes market and longevity risk
Lump sum offers control, flexibility and an inheritance
Lump sum can be rolled over to an IRA tax-deferred

Weaknesses

Many pension annuities lack inflation adjustments
Annuity payments usually end at death unless a survivor option is chosen
Lump sum exposes the retiree to market losses
Lump sum can run out with overspending or a long life

Good to know

Spousal consent is generally required to waive a joint-and-survivor annuity in plans that offer one.

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.