Take your (pension) lumps

Is it better to take your pension as a lump sum or an annuity? Walter Updegrave tells you how to make sure you're getting the most from your retirement dollar.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife and I are planning to retire next year when I'll be 59 and she'll be 60. Together we have about $600,000 in a 401(k), plus I have a pension that I can take as a lump sum of approximately $1 million or as an annuity that will pay $60,000 a year to me or my wife as long as one of us is alive. I'd prefer to take the lump sum and invest the money myself. I'm thinking of laddering bonds plus investing in some mutual funds to hedge inflation. What do you think of my plan? - Peter, Princeton, New Jersey

Answer: For people like you who are lucky enough to have an old-fashioned defined-benefit company pension, the decision whether to take that benefit as a lump sum or as annuity payments for life can be a toughie. After all, a check-a-month for life takes a lot of uncertainty out of retirement and can give you a nice feeling of security. Indeed, research shows that people who have such pensions tend to be happier in retirement.

But the lump sum also has its advantages. You have more leeway for how much of your money you can take at any given time. And if you and your spouse die before it runs out, you can pass it along to your heirs. Of course, both have downsides. If your company runs into problems and can't afford to pay the pension, you could end up with lower payments. (Yes, the Pension Benefit and Guaranty Corp. does provide backup in such cases, but you could still end up losing some of your benefits.)

Since company pension payments are typically fixed, inflation will eat into your purchasing power over time. And while you may be able to invest your lump sum in a way to provide inflation protection, there's also the possibility that you could run through your money while you and your spouse still have lots of living to do.

But assuming the facts you've given me are correct, I think it's pretty clear that in your situation you ought to take the money and run. Why? Well, if you took the lump sum today, went to an insurance company and bought an immediate annuity that would guarantee you and your wife an income as long as either of you were still alive, you could get about $64,000 a year, according to our Income For Life calculator. And since that figure is based on an average of what insurers are now offering, I think you could easily do better with a little shopping around (which you can do by clicking here.)

It's possible the situation could be different next year, so you should check again closer to retirement time. But unless things change fairly dramatically, it would seem there's no advantage to taking your employer's annuity payments even if you wanted your entire pension in the form of monthly payments.

Of course, you say you prefer not to take your pension benefit in annuity payments. Fine. But you may want to consider converting a portion of your pension into guaranteed lifetime payments for you and your spouse. You could do that after you retire by rolling both your 401(k) money and the lump sum from your defined benefit pension into an IRA rollover account.

You could then use some of the money in that account to buy an immediate annuity. (Make sure the annuity is held in your IRA rollover. If you withdraw cash from your IRA rollover and then buy the annuity, you'll have to pay cash on your withdrawal, leaving you with fewer dollars for the annuity.) By doing this you would get the advantages both of having an assured income plus the ability to manage your retirement savings on your own.

How much might you consider "annuitizing," as they say in annuity-speak? Well, that depends on how much guaranteed income you think you need. Some people feel comfortable covering much of their basic living expenses with Social Security and other sources of guaranteed income, like a pension or annuity payments. They can then tap other assets like mutual funds, stocks and bonds for discretionary expenses like traveling and entertainment and emergencies.

A diversified portfolio of stocks and bonds can also provide the long-term growth you need to keep your purchasing power ahead of inflation, and act as a reserve in the event you meet big health care expenses later in retirement. (For a story that goes into more detail on how to pull off such a strategy, click here.)

But it's really a matter of deciding how much you want in guaranteed income beyond Social Security. You can check how much you and your wife might receive from Social Security at various retirement ages by clicking here. If you think you'd like more assured income, then you can devote some of your IRA rollover to an immediate annuity - or not, if you feel Social Security gives you enough guaranteed income.

You and your wife are pretty young by retirement standards, so there's no need to rush into buying an immediate annuity. You might want to get at least a few years of retirement under your belt so you have a better feel for your spending needs, and then make a decision.

Remember too that you don't have to buy all your annuity income at once. You can buy annuities in small chunks, adding more income later on if you think you need it. In fact, annuitizing over time has a couple of advantages.

For one thing, since annuity payments go up and down with interest rates, buying at different times prevents you from locking in all your annuity income when rates are at a low. And since you're not buying all at once, you can easily diversify by buying from a different insurer each time (although, of course, you can also split your money between two insurers if you're buying an annuity only one time).

Diversifying gives you an extra measure of security in the event an insurer runs into financial troubles. Sticking to insurers with high ratings from firms like Standard & Poor's and Moody's greatly reduces the chance you'll have any problems. But there's nothing wrong with the belt-and-suspenders approach when you're dealing with money that has to support you the rest of your life.

As for how to manage the money you keep in stocks, bonds and mutual funds, I think your basic approach is right on. You want to keep some of your assets in stocks or stock mutual funds where you have a good shot at earning long-term returns that can outpace inflation. And you want some in bonds or bond funds that can provide income and some ballast during market squalls. I'm fine with your idea of laddering your bond portfolio - that is, dividing it equally among bond issues ranging in maturities from, say, two to 10 years, and then plowing the proceeds of a bond that comes do into a new 10-year bond.

But I think someone who doesn't want to devote the time to creating a laddered portfolio can achieve largely the same effect by investing in an intermediate-term bond index fund, like the one we recommend in the MONEY 70.

How much you devote to stocks vs. bonds is largely a matter of how long you want your money to last and what sort of risk you're comfortable taking. I'd caution you, though, against hunkering down too much in bonds. As a general guideline, someone your age should probably have roughly 55 percent to 60 percent of his portfolio in stocks and the rest in bonds. You can then pare back your stock exposure as you age, although even in your early to mid 80s you probably want to have a good 25 percent to 35 percent in stocks.

But this is only a general guide. You can invest more conservatively if you're the type who reaches for the Maalox every time the market sags 100 points, or you can invest more aggressively if you've got enough income from other sources so that short-term setbacks in your stock and bond portfolio won't affect your lifestyle. (If you'd like to see how different mixes of stocks and bonds affect how long your portfolio will last with a given withdrawal rate - or, for that matter, see how changing the amount you withdrawal will affect your portfolio's longevity - click here.)

All in all, though, it sounds like you've got a pretty good grasp of your situation. And if you take it slowly and think things through, I think you and your wife will do just fine. Top of page