If you’re lucky enough to win the lottery or you have a pension plan, you may need to decide whether you want to take your earnings as a lump sum or an annuity. If your goal is to maximize your earnings, you may want to consider your projected lifespan, inflation rates and your personal spending and investing habits. We break down the differences between a lump sum payment and an annuity, plus offer examples to help you decide which one to take. If you have questions about managing your retirement money, talk to a local financial advisor today.
Lump Sum vs. Annuity
A lump sum payment often consists of multiple payments over time. A lump sum allows you to collect all of your money at one time.
On the other hand, an annuity is a series of steady payments that are made at equal intervals over time. These time periods could be weekly, monthly or annually. An annuity allows you to regularly collect part of your money over a pre-specified time frame.
Pros and Cons If You Have a Pension
If your employer offers a traditional defined-benefit pension plan, you may have to make a tough choice when you hit retirement. Should you take a lump sum or choose monthly annuity payments for the rest of your life, and maybe for the life of your spouse and/or beneficiaries’ lives?
Before deciding, let’s look at the pros and cons of both instances:
|Pension Plans: Lump Sum vs. Annuity|
|Lump Sum Payment||– You can pay large debts off quickly |
– Left over money from a lump sum can be passed on as inheritance
– Can invest large amounts of the money sooner
|– Your retirement money could run out before you die if not managed properly|
|Annuity||– You will have an income for the rest of your life |
– You may be able to pass this lifetime income on to your spouse or a different beneficiary
|– Annuities might give you less financial flexibility in life |
– You may die before ultimately collecting all of the retirement money you’re owed
– Some annuities may not pay benefits to your family or beneficiaries in death
– The annuity might be too small to cover your medical bills if you are very sick
Analyzing Your Options
After weighing the pros and cons, you should analyze your own situation. A simple analysis compares the monthly payment amount offered with what you believe you could generate by investing this lump sum at about the same risk level. There are three factors to consider with this analysis: life expectancy, return on investments and risk of return.
Life expectancy is the most important factor of the three. For reference, the average life expectancy in the U.S. was just under 79 in 2019. But the U.S. Centers for Disease Control and Prevention (CDC) says in a recent report that those living at 65 could expect to live until almost 84 and those living at 85 could live until almost 92.
If you’re healthy, or have a good reason to believe that you or your spouse will live beyond the average life expectancy, monthly payments might be more attractive to you. If your spouse is significantly younger than you, that also might play a role in your decision. However, unless you choose a survivor benefit or term certain option, your annuity payments will stop when you die. The survivor benefit allows your heir to receive the annuity payments for their life span after you die. The term certain option offers you payments that decrease a little every month, but that will continue to your heirs in the case that you die.
However, if you’re in poor health and don’t expect to live beyond the average life expectancy, or you retired later in life, you may get more out of the lump-sum option. You can leave a lump sum for your heirs. And while managing that lump sum, it may be smart to overestimate how long you will live. Running out of money at 95 because you thought you would only live to 80 is not a fun prospect.
Return on Investments
If you already have a sufficient retirement income – whether through Social Security benefits, other existing annuities or other forms of lifetime income – you could take either the annuity payments or a lump sum and invest the money for yourself or your heirs.
Some companies offer a partial annuity, which would allow you to take part of your pension as a lump sum and part as an annuity. If your company doesn’t offer that, you could take the lump sum and purchase your own fixed annuity through a private company. You might be able to find an annuity plan that will guarantee you more money than your pension program. Another option is putting part of the lump sum towards an annuity, and investing or spending the rest of the lump sum however you choose.
It might also be a good idea to take the lump sum and roll it over to an individual retirement account (IRA). A direct rollover to your IRA from your employee plan is not subject to immediate taxation and can preserve the tax-deferred status of this money, while allowing it to be invested.
Risk of Return
If you are concerned about the reliability of your retirement income, you might want to take the annuity for the security. If a lot of your retirement income is dependent upon the market rather than guaranteed, the security might be a better bet for retaining a certain minimum lifestyle.
However, if you’re choosing the annuity payout for the security, you should check the credit rating of the pension fund or annuity provider. The Pension Benefit Guaranty Corporation (PBGC) is a federal government agency that provides limited protection for some private sector pension participants. If you’re really concerned about losing your pension because of the pension provider’s financial situation or inability to pay out, taking the lump sum may end up being the more secure option.
If your annuity does not have a cost-of-living adjustment, it’s purchasing power will decrease over time due to inflation. You can invest a lump sum in low-risk stocks, bonds or securities to help your assets keep up with inflation. However, doing so involves taking on some risk, and it doesn’t mean your income will last for the rest of your life.
Pros and Cons If You Win the Lottery
While those with a pension plan may have until retirement to decide, lottery winners have to choose quickly if they are taking a lump sum cash option or yearly annuity payments. Let’s look at the pros and cons of both options:
|Lottery Winnings: Lump Sum vs. Annuity|
|Lump Sum Payment||– You can use the money right away and however you choose, such as investing it||– The lump sum payment will be less money than the reported jackpot because the total amount is subject to income tax for that year and there’s a deduction for taking the lump sum payment |
– Your money could run out if not managed properly
|Annuity||– Annuity payments typically end up being a larger amount than the lump sum |
– Some annuity payments may be taxed at a lower rate
|– Annuities might give you less financial flexibility in life |
– You may die before ultimately collecting all of the money you won
Making a Decision
As with a pension plan, it’s important to analyze both payment options before you make a final decision. The two most important factors to account for are your life expectancy and return on investments. Here’s a breakdown:
If you choose the annuity option, you will either get equal payments for a period of time, or inflation-adjusted payments for a period of time. This could offer you more financial security for years to come. You should note that the Federal Reserve tries to keep the inflation rate between 2% and 3%. However, consumer goods and services during the 12-month period ending in July 2021 increased 5.4%.
For example, if you take the annuity and end up spending a year’s worth of money in six months, you get a chance to start over the next year with your next annuity payment and learn from your mistakes. Or if you’re young, you might prefer the extended payouts, since you’re going to live a lot longer and may want to guarantee a comfortable standard of living.
If you’re older, the lump sum of money now will allow you to enjoy it in your sunset years. If you have kids, choosing the extended payout means your heirs receive the remaining installments when you die.
Return on Investments
On the other hand, if you’re a good investor, or work with a good brokerage or financial advisor that you trust, you can potentially turn that lump sum of money into much more through investments. The amount could end up growing to be more than the initial jackpot winnings and what you would have taken home through had you chosen the annuity.
As with the pension money, you could also take the lump sum and purchase your own fixed annuity. There is the possibility of a higher return when you purchase your own annuity than when taking the lottery annuity. You could also try investing in low volatility, dividend-paying stocks, and effectively create your own annuity.
Even if taking the lump sum is theoretically a good decision, it might not be a better decision for you. Many lottery winners end up taking the lump sum and spending all their money in a few years. Taking the annuity option gives yourself time to figure out how you want to manage your money, and protects you against yourself as well as anyone who might take advantage of you.
The trade-off ends up being between security and maximizing your winnings.
If you’re receiving a large sum of money from your pension plan or lottery winnings, it’s important to analyze both payout options before choosing the lump sum or annuity. While an annuity may offer more financial security over a longer period of time, you can invest a lump sum, which could offer you more money down the road.
Take the time to weigh your options, and choose the one that’s best for your financial situation. You really want to make sure you’re choosing the right option for you and your family.
Tips for Maximizing Your Savings
- Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you receive a large sum of money, be sure to budget accordingly. Consider creating a completely new budget and adjusting your long-term financial goals. The extra money will let you pay down debt, which will help you even more in the end.
- While it may be intimidating, investing your money is one of the best ways to grow it over time. Start by choosing an online brokerage account or robo-advisor if a financial advisor isn’t right for you.
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