Pension Lump Sum or Annuity: 5 Swing Factors

Jason Stipp: I'm Jason Stipp for Morningstar.

Pensions are definitely a dying breed for today's working force, and those who do hold pensions may have concerns about pension funding and pension health, all serving to up the stakes on that important decision of choosing a lump sum from a pension or to annuitize that pension.

Here to offer some insights on making that decision is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, there are concerns about pension health, both public pensions and the fewer and fewer private companies that offer pensions. Some folks may look at that, be concerned about a pension, and just want to take that money as a lump sum and run. But you have a few considerations here. The first one we'll talk about is the all-important pension health. What should I think about if I have a pension, and how should that potentially color my decision?

Benz: Well, you are right, Jason, most people do take the lump sum because they want to disentangle themselves from their employer. The key thing to look at is the health of that pension, and you can do your due diligence on this topic in a couple of different ways. Your employer should be providing you with what's called a "pension funding notice" that gives you a sense of how fully funded your pension is or is not.

If you can't get your hands on that pension funding notice, look for a Form called '5500." This is something that your employer must file with the government, and you can check this out on a website called FreeERISA. You may need to sign up and provide a little bit of information, but then you can download pension information specific to your individual pension.

Stipp: So, an important thing in making this decision also is that if you choose to annuitize that pension, it's not like you have no protections from possible financial problems with your employer. There are some protections in place for those folks that annuitize.

Benz: There are, and that's what the Pension Benefit Guaranty Corp is there to do. It's there to backstop pensions that run into funding difficulties. And the PBGC has done a pretty good job to-date helping out some of these troubled pensions. But I think the big concern going forward is with these black clouds hanging over so many pension systems, whether it will be able to continue to do so. So that's where some investors have been concerned. PBGC has been pretty good to-date; will it always be in the future?

Stipp: So, first consideration is getting a sense of your pension's health and thinking about the guarantees and the strength of those guarantees potentially. The second important consideration are the other income sources that you have. So, how does that play into this decision?

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Benz: I think you want to think about overall household diversification. I would say if you and your spouse have a lot of your income needs, your very basic income needs, covered by other steady sources of income, maybe Social Security--maybe a spouse's pension, maybe some other pension that you will be able to draw upon during retirement--to me that argues more in favor of taking the additional pension as a lump sum versus the annuity. I think you are looking for that overall diversification. If you have a lot of your income needs covered, you may be smarter in fact taking that lump sum and looking for a higher return by perhaps having a greater stock percentage in your overall household portfolio.

Stipp: Consideration number three, an important one, my longevity--how long I think I am going to live. How does that play into [the decision], and how do I get a handle on that?

Benz: This is a really big swing factor, obviously, a very hard thing to get your arms around. But the reason it's important is that the longer you expect to live, the more that annuity is going to be the better choice for you. The reason is that the annuity will last throughout the rest of your life. And if you choose a joint pension benefit that pays not just during your lifetime, but also over your spouse's lifetime, that's going to be even more valuable. So the more that you have a history of long-lived individuals in your family, the more that favors the pension option.

And certainly as you are nearing a decision like this, maybe you are in your 50s and 60s, you also are starting to get a good sense of your own health and your own longevity expectations.

If you have been relatively healthy to-date, that would argue for the annuity being the better bet. If you have had health difficulties, or if you have a history of family members who have not lived very long lives, that would argue more in favor of taking a lump sum.

Stipp: So if you do take that lump sum, the longer you end up living, the harder that lump sum will have to work for you over time, and the more benefit you would see if you went ahead and annuitized, given that longevity.

Benz: Exactly.

Stipp: The next one, Christine, is a timely one, and that's interest rates. And we all know that they're very low right now. How might that color my decision at this point in time?

Benz: This is something that affects anyone purchasing any sort of annuity product, not just people with pensions who are looking at the annuity option. And the reason is that, life insurance companies or companies that provide annuities are looking at a couple of key factors when deciding how much to pay out. One of the key things they're looking at is where interest rates are and what is a safe return they can expect to earn on that money.

Given how low yields are, insurers are pretty timid about making very rosy forecasts about what kind of payments they want to make over people's lifetimes. That's why annuity payments are very, very low right now. If you are considering an annuity payment from your pension, recognize that you are locking in what could be historically low interest rates, which in turn will affect your annuity payouts.

Stipp: So just another way that low interest rates are bedeviling decisions for folks entering retirement.

Number five, Christine, if you do take the lump sum, that money is not going to invest itself, so my skills as an investor should also play a role in this decision.

Benz: Right. So you want to think about your own investment acumen. If you are someone who, when you look back on your track record as an investor (and hopefully you've been keeping a little benchmark of how you're doing versus maybe a blended benchmark with a similar asset allocation), be honest about how you've done.

If you've been someone who has not exhibited great investing acumen over the years, that argues in favor of taking the annuity instead. There have been some research studies that have actually pointed to the average person taking a lump sum underperforming over time what they would've gotten by simply annuitizing.

Another factor in the mix is that as people age, sometimes their cognitive abilities decline, and that in turn can affect their ability to invest well. That argues for using a "set it and forget it" type of vehicle, and an annuity certainly fits that role really well. So if you're concerned that you would like to take a hands-off approach to your investments, that you'd like your paycheck to come in regardless of any oversight that you might need to exercise, that argues in favor of the annuity.

Stipp: A lot of important inputs to this decision. Your last tip for investors is that it might be a good idea to seek some professional help here to make this very important choice.

Benz: Absolutely. So there's a lot of number crunching that can go on. So you can look at various return expectations that you would need to earn if you had the lump sum, and you can also factor in life expectancy into the mix as well. You can turn to a CFP, for example, to help you crunch those numbers.

My key piece of advice, though, is, if you are looking for guidance on this question, go with someone who doesn't have a vested interest in what you choose.

So if you're talking to a commission-based advisor, for example, recognize that that person probably has a strong vested interest in having you take that lump sum, and then he or she can help you invest it. Ideally you don't want someone who has a vested interest in this decision.

Stipp: So a very important decision, a lot of key inputs, made a little bit easier now with these expert tips. Christine, thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.