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Lump Sum versus Fixed Annuity Payments

Determining whether one should take a lump sum payment from your company pension plan or defer those payments by receiving annuity payments over your life can be a difficult decision. This is a decision many soon-to-be retirees may face if their employer has funded a pension or annuity for you during your career. When faced with this decision, there are a number of important questions you need to have answered in order to make an informed decision.

  1. What is my hurdle rate?

By determining the Internal Rate of Return (“IRR”) or discount rate on the annuity payments, you are able to calculate the hurdle rate. The hurdle rate is the rate of return you would have to earn on the lump sum to equal the stream of annuity payments you receive for your life. For example, if your hurdle rate is 2%, it makes more sense to take the lump sum and invest it than to take the annuity payments. On the other hand, if your hurdle rate is 12%, it’s a lot easier to justify taking the annuity and locking in that rate of return.

  1. How is your health & family longevity?

When one will pass away is the ultimate unknown, but it is also an important factor in determining which of the two options will be more beneficial. If you take the annuity and pass away just a few years later, the total value of your monthly income stream will likely pale in comparison to what you would have received had you taken the lump sum. If you are in poor health, the safer bet would likely be to take the lump sum. However, if you are in good health, the opposite may be true. Consideration should also be given to the longevity of your immediate family – parents and siblings. Often, if your parents have lived a long life, the probability that you will too increases.

  1. What is the institution’s credit quality & longevity?

Deciding to take the annuity payments until death does not always guarantee that the institution will be in a position to make those ongoing payments. For example, if you make the decision to take the annuity payments and the corporation subsequently experiences financial difficulties, you stand to lose the annuity payments. This point is not meant to scare you, but to make you cognizant of the credit quality of the institution with respect to your decision.

  1. What are your current cash flow & income needs?

Having immediate cash or income needs may weigh in your decision to take the lump sum. Having a strong financial position may better allow you to take the annuity. Also, understanding your tax situation and how current income versus rolling over a lump sum is going to affect your tax bill is important. For example, the lump sum option provides flexibility on the timing of taxable events prior to age 70 ½, but may increase your required minimum distribution once you attain age 70 ½.

There are a number of factors to consider when determining whether to take a lump sum or annuity payments over your life. We hope this information helps you in making that decision.

Written by

Jimmy Stechschulte, CFA®

As a member of the Investment Committee, he performs investment research on both equity and fixed income products to help construct diversified portfolios for clients. Jimmy also meets with and assists clients with financial and retirement planning needs, estate planning, and tax planning issues.

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