Having enough income in retirement is a primary concern for everyone approaching the end of their careers. Social Security offers monthly income to most Americans after they retire, and for many, the only other potential source of support during retirement comes from the savings that they've managed to squirrel away over the course of their careers. However, some workers still have access to pension benefits through their work, and the additional financial support that a pension can provide in retirement can make the difference between being comfortable in your retired years or struggling to make ends meet.

One of the most important choices that workers who have pensions through their jobs have to make is what to do with their pension benefits after they retire. Many pensions offer workers the choice either to take a lump-sum payout of their accumulated benefits at retirement, or to accept regular monthly payments that typically last at least for the remainder of their lives. In some cases, annuity options that pensions offer can also include benefits for a surviving spouse after the worker passes away. Making the best choice for your own personal situation requires taking a close look at the exact provisions of your own pension plan, but the factors you'll generally have to take into consideration are similar no matter what specific pension plan provisions apply to your case.

Employee Pension Plan booklet next to a calculator.

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How lump-sum pension distributions became an option in the first place

Historically, pension payments almost universally took the form of monthly payments. This arrangement matched up well with the expectations of both employers and employees. Retired workers were able to use expectations about pension income to budget what their financial resources would be in retirement, taking monthly income and allocating it against their expected monthly expenses after they stopped receiving an ordinary paycheck. Meanwhile, for employers that had assumed the responsibility of providing for the financial well-being of their workers after the end of their careers, the opportunity to space out payments over the course of their retirees' lifetimes was more financially manageable than having to come up with vast sums of money immediately upon a worker's decision to retire.

However, in managing pension plans, companies took on a substantial amount of risk. Company pension plans had to make sure to invest in such a way that the money they set aside to cover future pension obligations would grow enough to cover those future payments. That left them vulnerable to financial market risk, because if the investments they had chosen to provide the growth necessary to fund future pension payments proved insufficient, employers would have to come up with additional cash as needed to pay benefits. In addition, if the assumptions employers had made about life expectancies of their retirees proved to be incorrect, then the pension plans would suffer the consequences of adverse mortality risk and have to make payments over a longer period of time than they had initially accounted for. That put further pressure on pension plan finances.

As a consequence of these risks, companies started to seek ways to control or eliminate the potential adverse impacts on their pension plans. The shift away from traditional pension plans toward employer-sponsored 401(k) defined contribution plans stemmed in large part from this desire, as 401(k) plans essentially shifted the burden of investment responsibility from the employer to its workers. Employers could simply choose whether to make contributions toward their workers' retirement savings through profit sharing or matching contributions, and then leave it to each worker to decide how best to invest their retirement accounts.

However, that only solved the potential problem of pension-related risk for future workers. In order to reduce the risk associated with current workers from whom companies didn't have the right to take away pension benefits entirely, companies started to offer lump-sum buyouts of pension obligations, either to newly retiring workers immediately upon retirement, or to existing pension recipients based on their then-current age and monthly payments.

This required the company to come up with a large amount of upfront cash, because the lump-sum payout would include the present value of expected monthly pension payments extending years or even decades into the future. However, once the employer and employee had agreed to terms, and the employer had made the lump-sum payout, there was no longer any risk for the employer to bear. That was beneficial for most employers, especially because their shareholders would typically accept one-time hits to earnings associated with mass buyouts of pension rights as extraordinary items with a generally positive impact on the long-term prospects of the business.

What annuity options do pensions typically offer?

If the idea of a regular annuity payment appeals to you, then the next step is to assess the specific annuity options your pension plan will offer you. It's important to understand that the annuity options a pension plan offers are typically much different from what you would be able to get if you went to a private insurance company and asked about annuity products. In particular, if you're expecting to get access to things like fixed deferred annuities, fixed indexed annuities, variable annuities, or other more exotic types of annuities and insurance products, you probably won't have much luck. As you'll see later, you'll have the option to consider such products on your own if you decide to take a lump-sum payment from your pension and then invest the pension proceeds, but don't count on your employer to offer every annuity product imaginable within the pension plan itself.

Most annuity options closely resemble the options you'd get from a single-premium immediate annuity. The simplest is the single-life option, where you agree to receive monthly payments for as long as you live. Once you pass away, payments stop, whether that happens the month after you retire, 50 years later, or anywhere in between.

Workers who are married often prefer to make provisions to ensure that their spouses will receive financial support even after the worker's death. Joint-and-survivor annuity options can meet the needs of these workers, as they give you the ability to receive payments that will last as long as either you or the person you name as your beneficiary remain living. You'll receive the payments as long as you live, and if your beneficiary outlives you, then the pension plan will make future payments to the beneficiary through the beneficiary's lifetime. In some cases, you can specify whether the payment your surviving beneficiary receives will be equal to the full amount of what you received while you were living, or will be reduced to reflect lower expenses for the survivor compared to what a couple would need. For example, a pension might pay you $1,000 until your death, and then pay $500 to your designated beneficiary, while another option might let the beneficiary get the same amount you did.

Finally, some pensions give you the right to ensure that the annuity will pay out over a certain period regardless of how long you live. For instance, if you elect a single-life annuity with a 10-year period-certain option, then if you passed away four years after you started collecting payments, your beneficiary would be able to get the remaining six years' worth of monthly benefits. In this example, if you lived longer than 10 years after retiring, the beneficiary wouldn't receive anything upon your death.

The challenge with all of these options is that your choice affects how much you'll get monthly. A single-life annuity with no period-certain option will generally give you the largest monthly payment. If you add a beneficiary under a joint-and-survivor option, the monthly payments you'll get will be less, because the expected joint life expectancy will be longer than your life expectancy alone. Similarly, adding a period-certain option will also reduce your monthly payment, because it eliminates the risk that you'll die soon after retiring and end up costing the pension plan a relatively small total amount of lifetime benefits.

The payment amounts workers receive from a pension can also vary greatly, both from plan to plan at different employers, and within a given plan depending on the worker's age and years of experience at retirement. Your plan's particular benefit formula will give you the details on what to expect, including the base amount and the impact of choosing other annuity options on the amount you receive.

Pros and cons of choosing annuity options

Picking an annuity option has a number of advantages. You can rely on the pension to provide regular income on a predictable schedule for the rest of your life, no matter what happens to your financial situation, and no matter what happens with the financial markets. You're not responsible for making any investment decisions, as the pension plan retains the responsibility for coming up with enough money to pay out whichever annuity option you selected.

However, there are risks involved with a pension annuity. You only have the right to monthly payments, so you can't get advances on future amounts from the pension plan. That can be problematic if you have an unexpected major expense, as you'll be faced with the unattractive option of having to borrow to pay the amount upfront, and then repay the loan as you receive future annuity payments.

There are also tax impacts of choosing an annuity pension payout. Typically, all of your monthly pension payment will be taxable. As we'll see later, that's better than paying tax on a lump sum all at once, but it's not necessarily as good as what can happen if you take a lump sum and use smart tax planning to manage it. Nevertheless, with broadly spread-out payments over your lifetime, taxes on an annuity payout that's fairly close to what you received in pay during your career will typically create a similar tax situation to what you saw when you were working.

How lump-sum pension distributions work

Lump-sum pension distributions are completely different from annuities. With this method, your employer simply makes a one-time payment to you. In exchange, you agree that you won't receive anything else from your employer and give a release from any further liability related to pension obligations.

The calculation of the actual lump-sum amount is somewhat complicated, but it generally depends on two things: the size of monthly payment you would have been entitled to receive had you chosen the pension annuity option, and the current prevailing interest rates at the time you elect to take the lump sum. In general, the lower the interest rate, the greater the lump-sum payout will be.

Arguably the most critical thing about taking a lump-sum distribution is how you arrange to receive the amount of the lump sum. The smarter move in nearly every case is to arrange to have the pension distribution rolled over into an IRA. That way, you can preserve the tax-deferred nature of your pension, only paying taxes on amounts as you withdraw them from your IRA.

However, you also have the choice to have your employer pay the amount directly to a regular taxable account. In that case, you'll typically owe tax on the entire lump-sum amount in the year you receive it. Often, the lump sum will be large enough that it can have a dramatic impact on the amount of tax you owe, pushing you into a higher tax bracket and creating an excessively large tax bill.

In general, there's little reason not to roll over a lump-sum distribution into an IRA. Doing so gives you maximum flexibility, as by the time you retire, you're generally eligible to take as large of a withdrawal from your IRA as you want without penalty. Meanwhile, if you choose not to take all of your money out, it can keep growing on a tax-deferred basis.

Pros and cons of choosing a lump-sum pension payout

The biggest advantage of taking a lump-sum pension payout is that you have complete control over the entire amount you receive. You can invest it in whatever way you like, choosing assets that have the potential to grow rather than simply paying a fixed monthly payment for the rest of your life. That's particularly important if you fear the possibility of high inflation, which can dramatically reduce the purchasing power of your annuity-based monthly pension payment. Although Social Security benefits are adjusted for inflation, most pension payments aren't.

In addition, having access to a lump sum lets you handle major financial emergencies more effectively. It might not be ideal, but you at least have the option of tapping into a substantial portion of your investment capital all at once, avoiding having to take on debt to pay a large expense.

However, there are definite negatives to a lump sum as well. Many people aren't comfortable taking on the responsibility of investing a large amount of money, and if you make mistakes, there's no guarantee the lump sum will be enough to last you the rest of your lifetime. Also, if you're not careful about managing taxes appropriately, then you can overestimate the after-tax value of what you'll have left of the lump sum to spend. That can be a rude awakening later in retirement, when it's too late to adjust accordingly. Most importantly, you have to have the discipline not to spend your money too quickly. Otherwise, you can find yourself running out of your lump sum too soon.

An option to get the best of both worlds

Finally, some people like the idea of splitting the difference, getting access to a partial lump sum while also guaranteeing some monthly income. There are a few pension plans that will give you the ability to get reduced monthly pension payments in exchange for a partial lump sum that's only a fraction of what the full lump-sum distribution would be. That can be the best of both worlds, granting you the flexibility of a lump sum while still preserving extra monthly income in a pension payment.

Even if your plan doesn't give you this option, you can always create an equivalent monthly payment by taking part of your lump sum and investing it in an immediate annuity. This insurance product uses a calculation that's basically the reverse of what a pension plan uses in calculating a lump sum, taking the amount you invest and coming up with an equivalent monthly payment. Just be advised that what an insurance company will pay you in an immediate annuity won't be as much as what a monthly payment from your pension plan would be, because insurers can take risks like your health status into account, things pension plans don't account for.

An example

To see how this might work, let's look at an example. Say that you're single and 65 and retiring from your job after spending 30 years with your current employer. You most recently made $60,000 a year and are entitled to a pension equal to 50% of your last year's pay. That works out to $2,500 a month from your pension, and you also expect to get $1,500 from Social Security every month. Your employer has also offered to pay you a lump sum of $300,000 if you want to give up your monthly pension payments.

If you take the $2,500 per month, then when you do the math, you can calculate that you'd need to live 10 years in order to get to a total of $300,000. That's less than half the IRS projection of 21 years of life expectancy for the typical 65-year-old. If you have health conditions that suggest you could fall well short of that life expectancy, then taking the lump sum would make more sense. For instance, if you pass away after just five years, then you'd only have received a total of $150,000, and your heirs would miss out on fully half of the lump sum amount you could have received.

Conversely, if you take the lump sum, you can invest it in a way that will generate income and investment gains. If you assume a total return of 7.5% per year, a $300,000 portfolio would generate $22,500 in annual returns, working out to $1,875 per month. That's close to but not quite as much as the $2,500 pension payment, and it's of course subject to the risk of much worse investment returns during your retirement years.

In this example, there are good reasons why different people might come to different conclusions about the best thing to do. However, if your company offered a much larger lump sum -- say, $600,000 -- then it would almost certainly make sense to take it. If the amount were much lower -- perhaps $150,000 -- then you'd almost never want to take the lump sum over the monthly pension payments.

The right pick for you

There's no one-size-fits-all answer for whether a lump sum or a monthly payment will work better for you. But in general, the more you have in other retirement savings, such as IRAs, the less need you have for the flexibility a lump sum can provide, and the more useful an added monthly pension can be. If you have no other savings beyond Social Security and your pension, on the other hand, having a lump sum offers a lot more flexibility in the event of unexpected big expenses.

A lot depends on your temperament. Some retirees love the idea of managing their own investments and ensuring that they leave a legacy for their loved ones, and if you're one of them, a lump sum can give you a much better opportunity to build up savings that will give your family a leg up financially. Other retirees find investing a burden, preferring to leave it to their former employer. Monthly pension income is a lot easier to budget for, even if it doesn't give you the same options in every circumstance.

You owe it to yourself and your family to make sure your pension works as hard as it can for you. You must consider carefully which pension options to choose, because once you've made your choice, it's generally impossible to change your mind. By knowing your own preferences about whether you want to be responsible for investing your retirement savings or would rather leave it in the hands of the pension plan, you'll be best able to make a choice you can live with for the rest of your life.

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