Pensions: Annuity or Lump Sum?

A retired reader asks if money left over for heirs makes the lump sum preferable.

Question: When I retired, I chose a lump-sum from my company's pension plan and rolled the money into an IRA instead of taking an annuity. I did this because it's my understanding that if my wife and I were to die after receiving just a couple of months of annuity payments, none of the annuity's value would be passed on to our children or other heirs.

By taking the lump sum and moving it to the IRA, on the other hand, our heirs will receive the IRA balance when we die. Do you agree with my reasoning on this issue? - Paul, Westwood, New Jersey

Answer: You're correct that if you take an annuity option from your company pension plan that promises to pay you and your wife a monthly income as long as either of you are alive - an arrangement that's known as a joint-and-survivor annuity in insurance circles - the payments typically cease when you and your spouse are gone and nothing would be left for heirs.

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It's also true that if you and your wife were to take the lump sum and roll it into an IRA and then die relatively shortly after retiring, your children or other heirs would receive the balance of your IRA.

So you're right on both counts. That said, this is a case where two rights still don't necessarily make the lump sum-to-IRA the best choice.

By setting up a hypothetical scenario where you and your wife meet an early death, you've stacked the deck against the annuity. The purpose of an annuity is to provide insurance against outliving your money should you and your spouse live long lives.

Clearly, if you know for sure that you're not going to live very long, an annuity is a poor choice. But what if you guys keep going and going? Will your IRA be able to support you for, say, 25 years? How about 30 or 35 years?

That will depend, of course, on how much you withdraw from the IRA each year, what sort of returns the financial markets deliver and how successfully you manage the funds or other investments in your IRA.

But running out of money - or going through so much of the IRA that there's very little left later in life - isn't just a theoretical risk.

Consider: A 65-year-old man has a roughly 50-50 chance of living to age 85 and a 25 percent chance of living to 91. A 65-year-old woman has a 50 percent shot of living to age 88 and a 25% chance of making it to 93.

The odds are even higher that at least one spouse of a couple both aged 65 will be alive at those ages.

Of course, your longevity may be higher or lower than those stats suggest depending on your family history, lifestyle and current health.

That's not to say that taking the lump sum and rolling it into an IRA might not be a wise choice. It can be. But another decision could be even better, so it's important that you go through the right thought process to arrive at the choice that's best for your circumstances.

Here's how I suggest you do that.

First, before you decide whether to take your lump or an annuity, consider the resources you'll have in retirement as well as your retirement income needs. Start with Social Security. If you're very close to retiring, then the Social Security Administration can tell you what size monthly benefit you and your spouse will receive. Alternatively, you can estimate that payment by going to one of Social Security's online benefit calculators. Remember, that payment is indexed to inflation, so it's purchasing power will remain largely constant over time.

Now get a handle on the expenses you'll face in retirement. You can do that by jotting down your monthly expenses on a notepad or, better yet, you might want to fill out an online worksheet, such as the one in Fidelity's myPlan Retirement Quick Check, that allows you to get into more detail. (You can use Fido's worksheet even if you're not a customer, although you'll have to register at the site.)

By comparing your Social Security benefit to your retirement expenses, you'll get a sense of how much of your monthly nut will be covered by this guaranteed government payment. If it covers all or most of your expenses, well, then you probably don't need much more in the way of guaranteed income. That means that you can likely get by drawing small amounts from your IRA or other investments for whatever cash you need in addition to Social Security without much fear of running through your stash. So in that case, there's probably not much need for an annuity.

But what if your Social Security covers only a relatively small portion of your retirement expenses, which I suspect will be the case for many people, you have to decide whether you would feel comfortable having another source of guaranteed income. Not necessarily enough to cover all your expenses. But perhaps enough so that you cover at least a good portion of your recurring expenses - food, housing costs, etc. - so that you know you have the basics covered.

Of course, you don't want to devote all of your resources to an annuity. You want to have a stash of assets you can dip into to pay for emergencies or unexpected expenses and to provide some long-term growth to better ensure you can maintain your lifestyle in the face of inflation. But it might pay to put some money into an annuity and then keep the rest in an IRA invested in mutual funds or stocks and bonds that can provide liquidity as well as a solid long-term return.

And, in fact, as I explained in a recent feature story in Money Magazine, I think that's a pretty good model many people should at least consider for creating retirement income.

Stick a portion of assets in an immediate, or income, annuity and keep the rest in IRAs and other investment accounts. Exactly how much you put in an annuity vs. an IRA and other investments is largely a matter of how much guaranteed income you want vs. how much liquidity and long-term growth you think you'll need (and how much, if anything, you want to leave for heirs). But I think devoting somewhere between 25 percent and 50 percent of retirement assets to an annuity is at least a good starting point for people to consider.

One final thing: as a practical matter, most employers give you an all-or-nothing choice - you can take all your retirement benefit in a lump sum or convert it all into an annuity. That might not be a problem if your retirement plan represents only a small portion of your overall retirement assets. You could take the annuity and then rely on other retirement savings for liquidity and long-term growth.

But if your retirement plan represents all or a very significant portion of your retirement assets, then taking the annuity might not make sense since doing so would leave you with lots of guaranteed income but no assets for emergencies, the occasional splurge and protection against inflation.

Even if that's not an issue, there's another factor you might want to consider - the financial stability of your employer. When you accept a company annuity, you're counting on your company being able to make good on those payments many, many years into the future. There have been cases where once healthy firms - think steel companies - have run into problems and subsequently reneged on those promises.

But there is a way to get your lump and your income too. You can take the lump sum, roll it over into an IRA and use a portion of those IRA funds to buy an immediate, or income, annuity from an insurance company. And, if you wish, you can also buy an annuity that would continue to make payments to your heirs if you or your wife die within, say, five to 15 years (although the payments will be smaller than if you choose a plain-vanilla lifetime income annuity where the payments stop when you and your spouse die).

To sum up, after going through the thought process I've just outlined, you may still decide that the lump sum-to-IRA route still makes the most sense for you. But you'll have made a more informed decision than one based solely on the possibility that you and your spouse might cut out earlier than you wish.