Why a Pension Lump Sum Option Is Better Than an Annuity Payment

Lump sum or annuity payments? Single-life benefits or joint-and-survivor benefits? Once you explore the risks and hidden costs, the right pension answer for you could come down to control.

A man holds a burlap bag with a money sign on it.
(Image credit: Getty Images)

Often, the decision to take a pension annuity option over an available lump sum option rests on which option provides the greatest income. And that makes perfect sense if all of the other factors relating to this decision are excluded from the due diligence process.

But when considering all the factors that accompany this decision, whether to take a pension annuity option over an available lump sum option becomes more about control than it does the amount of the payment.

The Problems with Pensions

Today we are seeing fewer pensions than we did 20 years ago, and there is a reason for this downward trend. The truth is that pensions are facing systemic problems, which is why we see private sector companies replacing these defined benefit plans with defined contribution plans, such as 401(k)s.

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There was a time when employees worked until they could no longer physically do their job, and when they retired they died shortly after. What we see today is employees retiring much sooner in the cycle and living longer, which translates to significantly higher pension costs that are simply unsustainable.

Speaking of sustainability, historically pensions have used 4.5% to 7.5% to calculate their projection of benefits and with interest rates far below this range, it goes a long way in improving the optics of the plans, but does very little to change their actual solvency.

Interest rates have been far below these percentages for decades and when you couple that fact with a projected 10-year benefit period you can see how the math appears great on paper. But the reality is that if someone retires in their 50s (which is most often the case when a pension is involved) and live well into their 70s and 80s, you can see that 10-year estimates are short of reality.

Nearly 1 million working and retired Americans are currently covered by pension plans that are in imminent danger of insolvency, according to a 2017 Daily News article (opens in new tab).

So, what happens if a pension is unable to pay its promised benefits? According to The Heritage Foundation (opens in new tab), the Pension Benefit Guaranty Corporation (PBGC), which is similar to the FDIC, found that for a promised benefit of $24,000 a year, they are insured only up to $12,870.

To compound the problem, this insurance has the same problem as the FDIC (opens in new tab). The FDIC has billions in reserves but has exposure to trillions of dollars in banks accounts. The same issue exists within the PBGC. The promise of insurance benefits is not mathematically supported. If PBGC goes insolvent, that $12,870 promise is really only able to cover $1,500 under the insurance benefit.

The concern here is that when you retire and are relying on an annuity payment from a pension, you are placing a lot of trust in the pension calculations. And if the calculations are off, there is not enough insurance to recover the loss.

A Lump Sum Gives You More Control of Your Assets

I began this article by suggesting that the decision to take a pension annuity payment over an available lump sum option often rests on which option provides the greatest income. But when you add it all up, the decision to accept a lump sum offer is more about controlling and preserving your future income sources than it is the annuity payment you are promised from the pension.

Now, I am not suggesting that all pensions are destined to go broke, but there should be consideration for this possibility when structuring your income sources that are designed to sustain you for the rest of your life.

By accepting a lump sum from the pension, you gain the control over your income assets. Even if the income generated from the lump sum is less than the promised annuity payment from the pension, you gain control over the assets.

Even without the risk of a default, this lump sum option is a significant factor when you consider the following:

  • Your income needs can fluctuate in retirement, and the control of the assets backing your income gives you flexibility to meet your income needs.
  • You’re in a better position to take care of your spouse if you were to predecease them by owning the assets and leaving them behind for your spouse to continue to receive income.
  • Your heirs can be the beneficiary of the assets after you and your spouse pass when a pension is guaranteed to disinherits your heirs since it doesn’t pass to your children. In some cases, a child could receive a vested portion of the pension not already paid out.
  • You have access to the assets if there comes a time in your life when you may need cash, and having control over the assets grants you that option.

If You Must Go with an Annuity, Single-Life Option Gives You More Control

Of course, not all pensions have a lump sum option, which means you have no choice but to accept an annuity payment. If that is you, there are a few things to consider before selecting your irrevocable annuity option.

As with a lump sum, the idea is to move as much into your control as possible. It can be tempting to accept a reduced benefit to support a spouse or loved one after your passing, but this option only hands more control over to the pension.

A single-life annuity option is often your highest monthly benefit, and it is the quickest way to get the most from the pension in the shortest period of time. The downside to electing this option is that it can leave your spouse with an income shortage because payments would stop after your passing. That is why if you are married and choose to make this election, your spouse must sign off on that decision.

So, you have two options to protect your spouse:

  • You can buy insurance outside of the pension. With this option you would accept the single-life benefit, taking the highest annuity payment and then paying a premium to an insurance contract that would pay a lump sum to the surviving spouse or children if you predecease them. This approach also gives you the flexibility of canceling the policy if circumstances change and the benefit is no longer needed.
  • Or you can buy insurance through the pension. In this case you would go for a joint-and-survivor annuity, electing to take a reduced annuity payment in exchange for the benefit to continue to your spouse if you were to predecease them. Essentially, you are paying for the insurance with your lower benefit amount. It is worth mentioning that this benefit only has one beneficiary, so it would disinherit the children if you choose this option.

The Hidden Costs of a Joint-and-Survivor Benefit

One important factor when going with a joint-and-survivor annuity is the cost of buying the insurance through the pension. Of course, you have premiums in either scenario but when purchased within a pension there are unique circumstances that most people completely overlook.

If your pension has a cost-of-living adjustment built into it, you should recognize that because a joint-and-survivor benefit is lower, it will receive a smaller cost-of-living increase than a single-life benefit would, which means that the difference between what the maximum benefit and the reduced benefit would be compounds over time. That translates to an ever-increasing cost for the insurance against inflation.

A quick example of this: Say you have a maximum benefit of $5,000 per month with a single-life annuity, and a reduced benefit $4,000 per month with a joint-and-survivor annuity. That leaves you with a monthly cost for the insurance of $1,000 per month. When you factor in a cost-of-living adjustment of 3%, that is 3% on the benefit being received. So 3% on $5,000 would be $150, whereas 3% on $4,000 would be $120, a difference of $30 per month. This income gap compounds over time. Projected out over 20 years, the gap grows to over $1,800 per month.

And if that wasn’t enough of a reason to not buy the insurance from the pension, consider the fact that the longer the pension recipient lives, the fewer years the spouse is receiving the insurance from the pension. When you think about this, buying the insurance from the pension means that you are accepting an arrangement where you are paying an ever-increasing monthly premium for a decreasing benefit.

And unlike a life insurance policy purchased outside of the pension system, this pension insurance for the spouse only extends to your spouse, unless you were to choose a child as the beneficiary.

Be Careful

Now, if you go with a single-life annuity and choose to purchase the insurance outside of the pension system, it is critical that the type of policy you purchase and the amount of insurance obtained are in alignment with what you need to protect your family. One misstep in this process can leave your policy at risk of lapsing or expiring, leaving your spouse vulnerable to a significant income gap.

To download my free guide that will take you through the process of determining benefits and the type of life insurance best suited for protecting the benefits, visit www.thepensionelectionguide.com (opens in new tab).

Benefits and guarantees are based on the claims paying ability of the insurance company.

Securities offered through Kalos Capital Inc., Member FINRA/SIPC/MSRB and investment advisory services offered through Kalos Management Inc., an SEC registered Investment Advisor, both located at 11525 Park Wood Circle, Alpharetta, GA 30005. Kalos Capital Inc. and Kalos Management Inc. do not provide tax or legal advice. Skrobonja Financial Group LLC and Skrobonja Insurance Services LLC are not an affiliate or subsidiary of Kalos Capital Inc. or Kalos Management Inc.

Securities offered only by duly registered individuals through Madison Avenue Securities, LLC. (MAS), Member FINRA & SIPC. Advisory services offered only by duly registered individuals through AE Wealth Management (“AEWM”), a registered investment adviser. Skrobonja Financial Group, LLC, Skrobonja Insurance Services, LLC, AEWM and MAS are not affiliated entities. The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax or legal adviser with regard to your individual situation.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Brian Skrobonja, Chartered Financial Consultant (ChFC®)
Founder & President, Skrobonja Financial Group LLC

Brian Skrobonja is an author, blogger, podcaster and speaker. He is the founder of St. Louis Mo.-based wealth management firm Skrobonja Financial Group LLC (opens in new tab). His goal is to help his audience discover the root of their beliefs about money and challenge them to think differently. Brian is the author of three books, and his Common Sense podcast (opens in new tab) was named one of the Top 10 by Forbes. In 2017, 2019, 2020, 2021 and 2022 Brian was awarded Best Wealth Manager, in 2021 received Best in business and the Future 50 in 2018 from St. Louis Small Business.