Let’s say you won the lottery. How do you want your money? Payments for life (an annuity) or all the money up front (a lump sum)?
Better yet, how would you spend that money? Where is the first place you would travel to, or what is the first thing you would buy? N would likely buy things she “needs”, which in her opinion are jeans and shoes (if it hasn’t been made apparent in previous posts, I am scared by her definition of “needs”).
Personally, I’m more interested in saving, being practical, and looking forward to that long-term purchase (beach house). I would probably do the responsible thing – pay off my debts and invest the money.
If I had to make a choice between a lump sum and an annuity, I would choose the lump sum. Think of the song lyric “I want money, lots and lots of money!” Give me a lump sum! I think most of you probably agree with me.
Many retirees are forced to make that decision upon retirement regarding their pension. They have to choose whether they want the pension in a lump sum or an annuity payment.
Even though I would personally choose the lump sum, I want to discuss the advantages and disadvantages of each choice.
Lump Sum Payment
When you choose a lump sum payment, you take all your money at once, forgoing any monthly benefit that your company would have paid you. Most of the time, when someone elects a lump sum, they choose to rollover the proceeds into an IRA, thereby deferring any potential tax impact.
- Flexibility – A lump sum payment gives the owner total flexibility in terms of how much they spend and when they spend it. Once the money is in an IRA, the owner can choose to take any or all of it.
- Investment control – When you rollover the money to an IRA, you take control of investing your money. If you are a “safe” investor (one you does not like fluctuation in value), then you can invest it with low risk, whereas a “risky” investor (one who can tolerate fluctuation in value) can invest it with higher risk. The opportunity to make more in the market is greater than if you choose the annuity payment option. It’s important to note that although you have the potential for gains, investing is inherently risky, and you may lose money by investing it.
- Protects your beneficiaries – If you elect a lump sum payment and die the next day, your beneficiaries will inherit all the money in the account. If you choose an annuity payment and die the next day, it’s possible that your beneficiaries will receive nothing. You worked all those years, accumulated all those assets, and then have nothing to show for it.
- Control over your income – This one is closely connected to flexibility. If you elect an annuity payment, that money will come in every year, regardless of whether you want or need it. This forced payment gives you very little control over your income and tax impact. However, having the money in an IRA means you are in control.
- Potential inflation hedge – It’s no surprise that the cost of living goes up over time. When I was young (did I really just say that?), the cost of a gallon of gas was $0.99. Electing to rollover your assets into an IRA gives you control of your distributions. As the cost of living goes up, your need for income will increase. A lump sum distribution allows you to increase how much you withdraw from your IRA, allowing you to “keep up” with inflation.
- Spending too much, too soon – If you choose a lump sum payment and spend it on a vacation around the world, then there may be no more left. Once you spend that money, it’s gone. There is no redo or second chance. You’re not getting more money from your company. Also, keep in mind that there could be tax consequences and penalties on withdrawals if you are under 59.5 years old.
- Personal responsibility – Yes, this can be a disadvantage. You are responsible for handling your money, making your decisions, and controlling your fate. You need to have the self-discipline to take on the personal responsibility for the lump sum.
- Market risk – Yes, your investments can lose value in the market. By rolling the lump sum into an IRA and investing it, you are assuming the risk of value loss in your investments.
By choosing an annuity, you are forgoing a lump sum and electing to take monthly payments for the rest of your life. The good news is that generally speaking, if you live for a long time, the payments will continue until you die.
The worst-case scenario, of course, is that you forgo the lump sum, take the annuity payment, and die the next day. You received only one payment and your family gets nothing. Hey, it could happen!
- You cannot outlive it – It doesn’t matter if you live until you are 80, 90, 100, or 110 years old. An annuity payment will pay you the same amount for as long as you live.
- Possible survivor benefits – Your pension may allow you to buy a survivor benefit (typically for a spouse). With a survivor benefit, your spouse may be entitled to continue receiving a benefit if you die prematurely.
- PBCG protection – The Pension Benefits Guarantee Corporation (PBCG) was designed to protect defined benefit pension plans (the kind of plan that offers a lump sum vs. an annuity option). If your pension plan goes belly-up, the PBCG will step in and pay you up to the defined limit.
- It’s easy to understand – This type of annuity is easy to understand. It works like a paycheck. Each month you will receive a deposit into your bank account.
- The payment is fixed – You will receive the same amount today as you will 5, 10, 20, and 30 years from now. There is typically no inflation adjustment with an annuity payment. Therefore, the actual value of your “paycheck” goes down each year. The negative impact of this over the years can be huge – remember when buying a movie ticket (not for a matinee) was only $8?
- Premature death – If you die too soon and don’t set up a survivor benefit plan (or if you do select a survivor benefit and both die soon), then your beneficiaries will not reap the full benefit of your labor. They may not get an inheritance from what you have rightfully earned.
- No flexibility – What if you need more money? You can’t get it. What if you don’t need the money at all? You can’t turn it off. Once you elect an annuity, there is nothing you can do. You will receive that payment every month whether you want it or not.
What Option is Right for You?
The choice you make is a personal one. It depends on a number of factors, including your other income sources, income needs, time horizon, health status, family situation, and other obligations. Choose wisely!
None of the information in this document should be considered tax advice. You should consult your tax advisor for information concerning your individual situation.