When you retire you want to reduce your worries and concerns. And besides health, there is nothing that retirees worry more about than income. That being the case, many are drawn to the idea of taking a monthly pension or payout from their retirement plan rather than the lump sum offer. There are benefits to this of course. But there are also some major league pitfalls. How do you decide between the two? In my experience, this decision isn’t as difficult to make as you might imagine. Here are 3 questions you need to ask yourself. Once you do, you’ll have a pretty good idea on which way to go.
1. What are your objectives?
For most people, the major goal is to maximize retirement income. But some people also want to have access to their capital and/or leave a large pile of cash for their heirs when they pass. There is nothing wrong with any or all of these objectives. What’s important is to understand what your motivations are. If you ONLY care about getting the most income, the payout option could be excellent. But if you also want to have the capital available and/or you want to leave something behind for the kids, the lump sum is probably a better choice. That’s because the payout usually stops when you die. And once you select the payout, you can’t ever access the capital. It’s gone. It doesn’t belong to you anymore. Again, if income is what you’re after, that doesn’t have to be a problem. But if you have additional needs, you need to understand you may forfeit those if you select the payout option.
2. Will you need an income stream that adjusts with inflation?
When you select a monthly payout, you trade in your lump sum for a series of payments as I said. Those payments will never go up or down. This can be a very good thing…or a very bad thing depending on your situation and what the future has in store for you.
The company who pays you (usually an insurance company) calculates how much money they’ll pay you over the period based on a few things. If the annuity is a “life annuity,” they try to figure out how long you’re going to live. They do this based on life expectancy tables. Next, they look at how much money they make on your money when they invest it. If interest rates are low, they earn less. If the insurance company earns very little, the payout you receive will be low too. The bottom line is that no matter what the situation is, once you sign up for monthly payments, they never change. But because people are living longer and the average inflation rate is about 3.2% inflation is a huge issue for most people. In deed, you’ll need 37% more income 10 years from now just to keep up your current standard of living assuming that 3.2% inflation average doesn’t get worse. If your income is derived from a payout, how are you going to make up that 37%?
3. Are you willing to take on any risk?
I don’t know about you but the older I get, the less risk I want to take. You’re probably in the same boat with me. That’s why lots of people are more interested in the payout and fewer interested in the lump sum these days. When you take the payout, you transfer the risk to the insurance company. Cool beans. For some people this is the determining factor and I can understand it. But before you sign on the dotted line, breathe deeply and think clearly.
I know you may not like risk (who does) but keep in mind that you take on risk no matter which way you go. If you choose the payout, you take on inflation risk, right? And you also take on the risk that the company who is supposed to make those payments will stay in business for as long as you live.
If you take the lump sum, you have to invest it; that’s true. And even if you invest it wisely, you will probably use a component of growth in your portfolio and that means you’ll take on some risk Pilgrim. But while the risk is there, you have to look at this as a long-term proposition and the long-term risks. For my money, the long-term risks of a growth portfolio are far lower than the long-term risks of taking a monthly payout. Here’s why:
a. Interest rates are low. I don’t want to get locked into a low payment for the rest of my life.
b. Inflation may be low now…but I would be foolish to think it’s never going to be a problem. The annuity payment doesn’t compensate me for inflation risk. Equity growth investing holds out the potential for growth.
c. Firm risk. I don’t want to put all my trust into a company that looks strong now…but may not be such a pillar of fidelity down the road. Been there…done that.
Bottom line? The best strategy depends on your situation and emotional make up. But before you decide which way to go, consider that you’ll have to live with your decision for life if you select the income payout.
Do you need to decide between a monthly income or lump sum? Which way are you leaning? Why?
Ronald Dodge says
December 2, 2010 at 3:05 PMI don’t like Annuities period Here’s why:
A: You have no control over those funds anymore. You are at their whim.
B: You are at the mercy of their financial health for as long as you live. This is also a good reason why to have Defined Contributions and not Defined Benefits, as with Defined Benefits, you are at the mercy of the health of the employer for as long as you live.
C: Your payments don’t go up with inflation in many cases, and even if it does, it’s not without a high cost for it.
Your A and B kinda fits into my C.
As such, I will rather take the lump sum method with my set of financial and investment rules over annuities.