Q&A: Retirement annuity vs lump sum

Dear Liz: I am 54 and considering retiring in three or four years. I have been fortunate to work at a Fortune 100 company for 30-plus years and have both a defined benefit pension plan and a 401(k). When I retire, we have the option of taking a lump sum or an annuity. Most financial people I talk to strongly recommend taking the lump sum, though I wonder if it is not just so there is more money to manage? My current inclination is to take the annuity (with survivor benefit for my wife). I think we can live off the annuity alone and use the 401(k) for emergency/fun/help-the-kids money, etc. I think if I took the lump sum and invested it, I’d always worry about what the market was doing. Am I off base?

Answer: Not at all.

Theoretically, you often can make more money by taking a lump sum and investing it than by accepting the annuity, which offers a lifetime stream of payments. But perhaps you’ve heard the quote “In theory, theory and practice are the same; in practice, they are not.” Anyone who knows much about behavioral finance knows there are many, many ways such a plan can go wrong.

You could pick the wrong investments, take too much or too little risk, trade too much or spend too much, and wind up much worse off than if you’d chosen the annuity. You could turn over the investing decisions to a pro, but there’s no guarantee that person won’t make mistakes. Even if he or she chooses great investments and allocates your assets well, your nest egg could still take a hit from the market.

If you were comfortable taking that extra risk to get the extra possible reward of more cash, accepting the lump sum would be the way to go. Since you’re not, there’s nothing wrong with taking the annuity. Opting for a survivor’s benefit means your wife will have guaranteed income should you die first.

Before you pull the plug at work, though, make sure you talk to a fee-only planner who charges by the hour to make sure your retirement plan makes sense. (Planners paid by the hour won’t have a vested interest in how you opt to manage your retirement funds.) Your assets probably will have to last 30 or 40 years, and you’ll have to figure out how to pay for the ever-escalating cost of health insurance. This can be a tricky process, so you’ll want expert, unconflicted help.

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  1. Liz- shouldn’t he also consider the possibilities of his company facing difficult times and his defined pension being scrapped or reduced? (As we have seen in the news over the last few years).

    • Liz Weston says

      His pension can’t really be “scrapped.” Pension plans can be frozen or discontinued, but participants typically get to keep what they’ve earned to that point. If the company defaults, the Pension Benefit Guaranty Corp. covers most pensions–although if he retires in his 50s, he’d have less protection than someone who retired later.

  2. Mike Zangerle says

    Hi Liz,

    Can you recommend any fee on,y planners in the Los Angeles area?


    • Liz Weston says

      I can’t recommend specific individuals but you can get referrals from garretplanningnetwork.com and NAPFA.org. I recommend interviewing at least three.

  3. I concur with Eric’s statement. I had received a healthy ESOP award from my ex-husband’s retirement fund upon our divorce. It was north of $200,000. and had a five year disbursement schedule. I got one disbursement and they just ignored the annual requests for disbursement and finally bankrupted out of the debt. I ended up with a settlement by the court for $8,000.00. I sure wish I would have had the option for the lump sum payment upon my divorce. Just a cautionary tale about lump sums vs. annuities.