NEW YORK (CNN/Money) -
Which is better in the long run, a monthly pension or a lump-sum payment?
-- G. Wallace, Jamaica, New York
Your question is a little like asking, What's better for you, food or water? Each serves a different function, and if we want to remain healthy we need both.
Well, that's pretty much the case with a pension vs. a lump sum too. Although it's certainly possible to get by having only one or the other during retirement, I believe you'll have much more financial flexibility and decrease the odds of running out of money before you run out of time if you have both.
The pros and cons of pensions
To see why that's the case, let's do a quick review of the pros and cons of each option.
First, let's take the pension. The obvious advantage here is that you're assured a given sum of money every month for the rest of your life (and, if you're married, perhaps for the life of your spouse as well).
That's helpful not only for budgeting purposes, but for emotional security as well. You don't have to worry about what effect the ups and downs of the financial markets will have on next month's income.
But there's a downside to a pension. For one thing, your payments may not rise with inflation. In fact, most corporate pensions -- unlike Social Security -- are not indexed to inflation.
That means that the monthly company pension you receive is certain in two ways: you're certain to get it, and it's certain to lose value in real terms: $1,000 a month today would lose about 26 percent of its purchasing power in 15 years even if inflation averaged a mild 2 percent a year.
And there's another drawback. If you need more money in a given month -- say, to meet an unexpected expense or simply to splurge on a vacation -- a pension isn't much help. It's only an income stream. There's no pot of money to dip into for extra cash.
The lump sum option
With a lump sum, on the other hand, you're not assured a given sum each month as in a pension. But if you manage the money well, you should be able to make regular draws from your portfolio and its earnings that simulate a pension.
And since you're the one deciding how to get that income from the portfolio -- dividends, sales of various shares, etc. -- you've also got some leeway to turn the tax laws to your favor. You can postpone sales of securities, for example, to assure any gains are treated as capital gains rather than ordinary income, which means more of the gain goes into your pocket and less into Uncle Sam's.
Similarly, you may also be able to sell some losing positions to create losses that will offset gains in other securities, which also trims your tax bill.
And since you've got a pool of securities (stocks, bonds and cash) rather than simply a promise of monthly income, a lump sum gives you the leeway to dip into your stash if you need more money in a given month either because an unanticipated expense has popped up or you simply want to indulge yourself a bit with a cruise or whatever.
The downside to a lump sum, however, is that if your investments earn subpar returns or you simply pull the money out more quickly than it has a chance to replenish itself, you could outlive your money, and face the prospect of having to live a much diminished lifestyle in retirement.
Why not both?
Which brings me to my point about doing both. By combining a pension with a lump sum, you get the advantages of each approach, while mitigating the disadvantages inherent in each.
In short, the pension gives you the stability of a certain sum of money coming in each month, while the lump sum provides a stash you can dip into when you need more cash in a given month for whatever reason.
There's also a growing body of research showing that combining a pension-like arrangement with systematic withdrawals from a portfolio can increase the longevity of one's retirement assets -- in other words, decrease the chance that you'll outlive your money.
There are a variety of ways to arrange your finances so you can effectively have both a pension and a lump sum to invest for retirement.
One way is to simply take your employer's lifetime pension option rather than a lump sum when you retire. But that's typically an all-or-nothing choice, so you would only take that option if you had other assets besides the pension that could act, in effect, as a lump-sum, or portfolio you could dip into when necessary.
If you don't have other assets, then you might consider taking the lump-sum option, but rolling it into an IRA rollover to preserve its tax-deferred status. At that point, you can then consider using a portion of that lump sum to buy an immediate annuity (aka a "payout" annuity), which is an insurance contract that promises to pay you a monthly income. In short, you would effectively be creating your own pension, while still leaving yourself a pot of money under your control.
You can create the same arrangement with money from a 401(k) or other tax-deferred company savings account -- that is, turn a portion of your money into an income stream via an annuity and leave the rest in a tax-deferred IRA rollover that you can draw from as needed.
I'll be the first to admit that the world of annuities can be a confusing, and expensive, place. And I'll also be the first to admit that an annuity isn't right for everyone.
But by doing a bit of research (which can begin here) and perhaps talking to an independent adviser (i.e., not somebody who primarily sells annuities for a living) you should be able to evaluate the issues involved and decide whether this combination of pension-like income combined with a portfolio of securities makes sense for your situation.
Or, to put it another way, whether you should have food and water as opposed to just one or the other.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.