Of all the investment decisions you may have to make, deciding whether to take a lump sum or annuity payout from your pension plan could be the most difficult.
The reason is that, unlike other decisions, there are few rules of thumb to guide you. That means that deciding between a one-time payment and a steady annuity payout must be based largely on your situation, experts say.
"Obviously, it's a highly personal issue," says David B. Root Jr., a financial planner with D. B. Root & Co. in Pittsburgh. "You have to tackle this issue on a person-by-person, case-by-case basis."
This issue - lump sum or annuity - most often surfaces when a worker takes early retirement or gets laid off. It can also be an issue at the time or an ordinary retirement, when a company gives you the choice. The decision comes down to this: Do you want the security of a predictable payout each month, even though pension plans are typically invested in a fairly conservative fashion, making for steady, unspectacular returns? Or do you want to take control of the entire sum that has been put aside for you, which gives you the chance to shoot for higher returns but leaves you facing the consequences if your strategy fails?
In spite of the risks, many investors opt for the lump sum, figuring they can do a better job maximizing their assets than a pension-plan manager can.
Before deciding, experts say, you should:
Add up your assets, including savings outside retirements accounts, IRAs, 401(k) and pension.
Figure out how much you expect to receive each month from Social Security and how much you would receive from your pension under the annuity.
Study your pension plan to find whether it has cost-of-living adjustments, which increase monthly payments in conjunction with inflation, and whether it has survivor's benefits for your spouse.
Assess how much will be needed each month for you and your spouse to live on comfortably.
Estimate your and your spouse's life expectancy.
Check inflation forecasts. Inflation can erode your nest egg and reduce what you have to live on.
Decide whether you want to leave behind an estate for your spouse, children or favorite charities, and, if so, how large.
Sound tough? It's only through that exercise - as imprecise as it seems - that you'll be able to decide what's best.
"Whether you take the lump sum is based on what you think you'll need to live on," says Morry Zolet, a senior vice president of investments for the local office of Salomon Smith Barney. "You'll need growth [once the lump sum is invested]. But if you spend some of that growth, and you have a bad market, you'll deplete some of the principal."
In deciding, make conservative assumptions. Assume that if you take a lump sum, your money will grow at an average annual rate of no more than 8 percent. That's about 3 percentage points less than the historical return of stocks but is reasonable because you'll probably put the money into stocks or stock mutual funds, bonds and cash investments such as certificates of deposit. Some experts advocate an estimate of 4 percent to 5 percent.
Say you have the option of an annuity at $1,000 a month or a lump sum of $80,000. At 8 percent, the lump sum would generate $6,400 a year, or $533 a month. That means you would need almost $500 a month from other investments to draw even. With a guaranteed annuity of $1,000 a month, you would need a lump sum of $150,000 to generate the same $1,000 each month ($150,000 with an 8 percent return yields $12,000 a year, or $1,000 monthly).
A larger lump sum, say $500,000, would grow by an average of $40,000 a year, or about $3,300 a month. If you believe that you can live on $40,000 annually in your retirement years, that lump sum might prove a sound option.