When you are planning for or nearing retirement, one question gets stuck in your mind: Should you take the lump sum or choose the annuity for your pension? Taking the lump sum means you’re going to receive the pension in full, while an annuity is a stream of monthly payments that will last you for life or, in some cases, even your spouse’s.

The lump sum is tempting because you can receive a large amount of money that you can use to travel, reinvest, start a business, and many other things. But it is also risky because it’ll be up to you to find a source of retirement income.

There are two types of pension funds: traditional pensions or defined-benefit plans and 401(k) or other defined-contribution plans. A defined-benefit plan sets a specific amount that the employers need to pay upon the employees’ retirement.

On the other hand, a defined-contribution plan has no guaranteed payment in retirement. Instead, it allows employees to contribute and invest money into their retirement fund. The employers will usually match the amount the employees will contribute.

Traditional pensions are often a huge risk for employers because they’ll need to provide monthly payments to retirees for the rest of their lives. They often offer lump sum payments to cut costs since this is a one-time payment that usually tempts retirees. But what is the best option for you?

The Health of the Company or Entity Providing the Annuity

The significant amount of the lump sum is not the only reason why some retirees choose it. If they aren’t sure about the company’s financial health, they’ll be better off with the lump sum amount too. Some pension funds are severely underfunded. The employers may soon stop paying the monthly pension checks.

Before you choose an annuity, check the financial well-being of the company. Your pension fund is required to provide you with an annual update, or you can simply check Form 5500 at FreeErisa.com. You need to look at the plan’s current assets and liabilities, as well as the percentage of funding. You need to see the last number to be 100 percent or close to that.

Annuities don’t just fly in the wind when your pension plan fails. Pension Benefit Guaranty Corporation can take over, but you won’t get everything. A 65-year-old retiree will get $67,295 annually from a single-employer plan. If he or she had multiple employers, the pensioner would only get a base amount of $35.75 per month times years of service.

There are two more reasons why you should take the lump sum amount. Most people would want their spouses to get 100 percent of the monthly pension after they die. However, some plans will only offer 50 percent or 75 percent of the original amount.

Secondly, if your pension plan does not allow you to take a portion of it for the emergency fund and have the rest paid monthly, you can just take the lump sum now.

Other Sources of Retirement Income

If you take a lump sum payment rather than the annuity payments, you might not be faced with the problem of withdrawing money earlier than needed from an IRA or 401(k) plan. Sometimes it makes sense to withdraw these funds before it’s necessary, but it usually leads to higher tax bills. By taking the lump sum payout, you can delay the withdrawal from accounts where the withdrawals are taxed at the full federal and state income tax rate.

Assurance of Guaranteed Stream of Retirement Income

Do you have another source of retirement income? Are you entirely reliant on the pension fund? If you take the lump sum and reinvest that money to get an annuity, how sure are you of your investment options? Is the lump sum enough to buy a rental space that can create a passive income, for example?

The longer you live, the higher the chance of running out of money. That lump sum payment can be gone in months when you make a wrong investment. How can you recuperate that money then? You can only take the risk of reinvesting the lump sum when you have another source of retirement income.

You need to consider what will happen to your spouse, too, after you die. When one spouse dies, the household income can plunge. Having an annuity that pays until the other spouse dies will help prevent poverty later in life.

That doesn’t mean you should ignore the benefits of taking the lump sum payment. You can control how it’s invested better. Plus, you can save more for an emergency. But this is only practical if you have other income streams such as Social Security and other defined-contribution plans.

The guaranteed income should cover the basic monthly expenses. Anything more than that can be used to multiply that income through investments and sound money management. Your monthly expenses in retirement should not rely on the performance of your assets. As you grow older, you will have less time and energy to manage your investments. At the very least, you need a steady stream of income to cover your basic needs. That is the role of an annuity.

The Takeaway

You can still choose to receive the lump sum provided that you will reinvest that into a more stable annuity for the future. A portion of that can be kept for medical emergencies. The only way you can retire comfortably is to ensure you have basic monthly expenses covered, whether through an annuity, investments, passive income, or a combination of all. It should be a steady and consistent source of income.

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