Take your (pension) lumps

Is it better to take your pension as a lump sum or an annuity? Walter Updegrave tells you how to make sure you're getting the most from your retirement dollar.

NEW YORK (Money) -- Question: My wife and I are planning to retire next year when I'll be 59 and she'll be 60. Together we have about $600,000 in a 401(k), plus I have a pension that I can take as a lump sum of approximately $1 million or as an annuity that will pay $60,000 a year to me or my wife as long as one of us is alive. I'd prefer to take the lump sum and invest the money myself. I'm thinking of laddering bonds plus investing in some mutual funds to hedge inflation. What do you think of my plan? - Peter, Princeton, New Jersey

Answer: For people like you who are lucky enough to have an old-fashioned defined-benefit company pension, the decision whether to take that benefit as a lump sum or as annuity payments for life can be a toughie. After all, a check-a-month for life takes a lot of uncertainty out of retirement and can give you a nice feeling of security. Indeed, research shows that people who have such pensions tend to be happier in retirement.

But the lump sum also has its advantages. You have more leeway for how much of your money you can take at any given time. And if you and your spouse die before it runs out, you can pass it along to your heirs. Of course, both have downsides. If your company runs into problems and can't afford to pay the pension, you could end up with lower payments. (Yes, the Pension Benefit and Guaranty Corp. does provide backup in such cases, but you could still end up losing some of your benefits.)

Since company pension payments are typically fixed, inflation will eat into your purchasing power over time. And while you may be able to invest your lump sum in a way to provide inflation protection, there's also the possibility that you could run through your money while you and your spouse still have lots of living to do.

But assuming the facts you've given me are correct, I think it's pretty clear that in your situation you ought to take the money and run. Why? Well, if you took the lump sum today, went to an insurance company and bought an immediate annuity that would guarantee you and your wife an income as long as either of you were still alive, you could get about $64,000 a year, according to our Income For Life calculator. And since that figure is based on an average of what insurers are now offering, I think you could easily do better with a little shopping around (which you can do by clicking here.)

It's possible the situation could be different next year, so you should check again closer to retirement time. But unless things change fairly dramatically, it would seem there's no advantage to taking your employer's annuity payments even if you wanted your entire pension in the form of monthly payments.
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Of course, you say you prefer not to take your pension benefit in annuity payments. Fine. But you may want to consider converting a portion of your pension into guaranteed lifetime payments for you and your spouse. You could do that after you retire by rolling both your 401(k) money and the lump sum from your defined benefit pension into an IRA rollover account.

You could then use some of the money in that account to buy an immediate annuity. (Make sure the annuity is held in your IRA rollover. If you withdraw cash from your IRA rollover and then buy the annuity, you'll have to pay cash on your withdrawal, leaving you with fewer dollars for the annuity.) By doing this you would get the advantages both of having an assured income plus the ability to manage your retirement savings on your own.

How much might you consider "annuitizing," as they say in annuity-speak? Well, that depends on how much guaranteed income you think you need. Some people feel comfortable covering much of their basic living expenses with Social Security and other sources of guaranteed income, like a pension or annuity payments. They can then tap other assets like mutual funds, stocks and bonds for discretionary expenses like traveling and entertainment and emergencies.

A diversified portfolio of stocks and bonds can also provide the long-term growth you need to keep your purchasing power ahead of inflation, and act as a reserve in the event you meet big health care expenses later in retirement.